Taxation on Capital Gains vs. Ordinary Income
Ordinary income and capital gains taxation are two prominent financial concepts. Understanding the difference between them that will help you to make wiser financial decisions.
Ordinary income tax applies to paid compensation, whether it is in the form of wages, property, or services. Ordinary income rates also apply to interest income, dividends, royalties, or self-employment compensation. Your income tax rate is based on your total annual income. Your income will fall into one of the seven federal income tax brackets. These brackets vary by year and filing status (single, married filing jointly, or head of household). Currently, federal income tax bracket percentages range from 10% to 37% of a person’s taxable income. The U.S. has a progressive tax system, meaning lower-income amounts are taxed at lower rates than higher-income amounts. Each dollar of a person’s income is taxed based off the tax bracket it falls into. For example, if you earn $15,000 this year, your first $9,875 will be taxed at 10% as it falls into the 10% bracket. The remaining $5,125 of your income will be taxed at 12% since it falls into the 12% tax bracket.
Capital gains tax, on the other hand, applies to the sale of capital assets, including stocks, bonds, and mutual funds. A capital gain, for example, would arise when you sell a stock for more than you purchased it for. If you purchase 10 shares of a stock for $10 a share and sell those 10 shares when the price per share is $12, you would have a $20 capital gain ($120- $100). There are both short-term and long-term capital gains. Short-term capital gains apply to the sale of capital assets that were held for less than a year. Short-term capital gains are taxed at your ordinary income rate. Long-term capital gains apply to the sale of capital assets that were held for over a year. Long-term capital gains rates are traditionally “tax preferred” compared to ordinary income rates. There are only three brackets for long-term capital gains: 0%, 15%, and 20%. The highest bracket for long-term capital gains, 20% is significantly lower than the highest bracket for ordinary income, 37%. Individuals realize a capital loss when they sell a capital asset for less than they purchased it for. If you sold those same 10 shares (as described above) when the price per share is $8, you would have a $20 capital loss ($80 - $100). Capital losses can be offset against capital gains on your tax return. It is important to note, however, that there is a capital loss limitation. The annual capital loss limitation is $3,000. If you have a capital gain of $2,000 and a capital loss of $6,000, $2,000 of that loss would be used to offset the $2,000 in capital gains. The remaining $4,000 loss can be offset against ordinary income. However, because of the capital loss limitation, only $3,000 of the $4,000 loss can be offset against income. The remaining $1,000 of the loss can be carried forward indefinitely and offset against future income.
Individuals can lower their tax burden by taking advantage of the capital gain’s preferential rates. For example, if you have been holding a capital asset for 11 months and are planning on selling it soon, it may be worthwhile to hold the stock for a remaining month to receive the preferential tax treatment. Consistently evaluating the tax consequences of your financial decisions will allow you to minimize the taxes you owe.
Source: http://news.morningstar.com/classroom2/course.asp?docId=144042&page=2#:~:text=Ordinary%20income%20includes%20items%20such,its%20purchase%20price%2C%20or%20basis.&text=If%20a%20stock%20is%20sold,the%20higher%20ordinary%20income%20rate & https://www.investopedia.com/ask/answers/052015/what-difference-between-income-tax-and-capital-gains-tax.asp