Different kinds of income are taxed differently under the United States tax system and two of the major distinctions are between ordinary income tax and capital gains tax. Ordinary income tax applies to income earned from regular activities such as wages, salaries and commissions. It also applies to interest earned on bank deposits. Capital gains tax applies when you sell a capital asset such as a stock, bond, real estate or other investment for more than you paid for it. A financial advisor can help you account for different taxes on types of income.
Ordinary Income Tax
Income earned from working for wages, salaries and commissions, as well as income earned from interest paid on bank deposits, is taxed as ordinary income. This type of income is taxed at your regular tax rate, also known as your marginal tax rate.
The marginal rate is determined by tax brackets. The IRS publishes annually updated income ranges for seven tax brackets that go from 10% to 37%. The percentage of tax applied increases as income rises.
For a simplified example of how this works that doesn’t account for deductions and other factors, a taxpayer who earns a $75,000 salary in 2023 will be taxed using the following tax brackets:
- 10% on the first $11,000 = $1,100
- 12% on the amount over $11,000 and up to $44,725. This amount is $33,725, so the tax would be $4,047
- 22% on the amount over $44,725 and up to $75,000. This amount is $30,275, so the tax would be $6,660.50.
The total tax on ordinary income in this simplified example is $1,100 + $4,047 + $6,660.50 = $11,807.50.
Capital Gains Tax
Capital gains tax applies when you sell a capital asset for more than you paid for it. Capital assets include stocks, bonds, jewelry, real estate and other investments. The tax rate varies depending on whether it’s a short-term or long-term capital gain and also on your income. Different capital gains tax rates may apply to specific types of assets as well.
Short-term capital gains result from sales of assets held for a year or less. These capital gains are taxed at your ordinary income tax rate. So, if you sell a stock you owned for six months and make a $10,000 profit, this will be added to your ordinary income and taxed accordingly.
Long-term capital gains from sales of assets held for more than a year receive a more favorable tax rate. Long-term capital gains rates for 2023 are 0%, 15% or 20% depending on your income.
For example, if you sell a stock you held for two years and make a $20,000 profit, the tax on this gain would be:
- 0% if your taxable income, including the gain, is up to $40,400
- 15% if your taxable income is more than $40,400 but not more than $445,850
- 20% if your taxable income is over $445,850
To combine this with the previous example involving an ordinary income of $75,000, adding a $20,000 long-term capital gain results in a total income of $95,000. This would place you in the 15% bracket for long-term capital gains. The additional tax on your $20,000 gain would be 15% of $20,000 or $3,000, increasing your total tax bill including ordinary and capital gains tax to $14,807.50.
Special Considerations
In addition to the basic rates, high-income investors may also have to pay an additional 3.8% net investment income tax. Also, certain types of assets have specific rules. For example, capital gains on sales of collectibles such as art and jewelry are taxed at a flat rate of 28%.
As well as making gains when selling assets, you may also experience losses. These losses can be used to reduce your overall capital gains for a given tax year and potentially reduce the taxes you owe. An investing strategy called tax-loss harvesting can be employed to make the most of money-losing asset sales.
The Bottom Line
Ordinary income tax applies to regular earnings like wages, salaries and interest and is taxed at your marginal tax rate, which varies from 10% to 37% depending on your income. Capital gains tax, charged when selling assets for a profit, varies depending on how long you owned an asset. Short-term gains on assets held a year or less are taxed as ordinary income, while long-term gains held for over a year have generally lower tax rates.
Tips for Tax Planning
- Careful tax planning is one of the most effective ways to increase your income and wealth and talking to a financial advisor can help with this important task. Finding a financial advisor doesn’t have to be hard.SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Check out SmartAsset’s Capital Gains Tax Calculator to find out how much tax you’ll owe when selling investments.
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FAQs
Income tax is paid on earnings from employment, interest, dividends, royalties, or self-employment, whether it's in the form of services, money, or property. Capital gains tax is paid on income that derives from the sale or exchange of an asset, such as a stock or property that's categorized as a capital asset.
What is the difference between a capital gain and ordinary income? ›
Ordinary income tax applies to regular earnings like wages, salaries and interest and is taxed at your marginal tax rate, which varies from 10% to 37% depending on your income. Capital gains tax, charged when selling assets for a profit, varies depending on how long you owned an asset.
What is the difference between income and capital gains? ›
Capital gains and other investment income differ based on the source of the profit. Capital gains are the returns earned when an investment is sold for more than its purchase price. Investment Income is profit from interest payments, dividends, capital gains, and any other profits made through an investment vehicle.
Why do individuals prefer capital gains over ordinary gains? ›
If you have a net capital gain, a lower tax rate may apply to the gain than the tax rate that applies to your ordinary income. The term "net capital gain" means the amount by which your net long-term capital gain for the year is more than your net short-term capital loss for the year.
What is the main difference between earned income and capital gains? ›
Earned income is payment for employment, while capital gains are produced by your investments.
Which tax rate is higher ordinary income or capital gains? ›
Gains from the sale of assets you've held for longer than a year are known as long-term capital gains, and they are typically taxed at lower rates than short-term gains and ordinary income, from 0% to 20%, depending on your taxable income.
Do you have to pay both capital gains and income tax? ›
Short-term capital gains are taxed at the same rate as your ordinary income. Meanwhile, long-term gains are taxed at either 0%, 15%, or 20%. The rate you pay is based on your taxable income. Just like with ordinary income tax rates, the higher your income, the higher your long-term capital gains tax rate.
Is ordinary income taxed before capital gains? ›
So, again, long-term capital gains are taxed at different rates and separately from your ordinary income. Your ordinary income is taxed first, at its higher relative tax rates, and long-term capital gains and dividends are taxed second, at their lower rates.
What qualifies as ordinary income? ›
Ordinary income is usually characterized as income other than long-term capital gains. Ordinary income can consist of income from wages, salaries, tips, commissions, bonuses, and other types of compensation from employment, interest, dividends, or net income from a sole proprietorship, partnership or LLC.
What income qualifies as capital gains? ›
Capital gains are the profits that are realized by selling an investment, such as stocks, bonds, or real estate. Capital gains taxes are lower than ordinary income taxes, providing tax advantages to investors over wage workers. Moreover, capital losses can sometimes be deducted from one's total tax bill.
Capital Gains Tax for People Over 65. For individuals over 65, capital gains tax applies at 0% for long-term gains on assets held over a year and 15% for short-term gains under a year. Despite age, the IRS determines tax based on asset sale profits, with no special breaks for those 65 and older.
What is the 6 year rule for capital gains tax? ›
Here's how it works: Taxpayers can claim a full capital gains tax exemption for their principal place of residence (PPOR). They also can claim this exemption for up to six years if they move out of their PPOR and then rent it out. There are some qualifying conditions for leaving your principal place of residence.
How to avoid capital gains tax over 65? ›
Utilize Tax-Advantaged Accounts: Tax-advantaged retirement accounts, such as 401(k)s, Charitable Remainder Trusts, or IRAs, can help seniors reduce their capital gains taxes. Money invested in these accounts grows tax-free, and withdrawals are not taxed until they are taken out in retirement.
How will you distinguish between capital gain and income? ›
A capital gain is when an investment rises to a higher price than an investor paid. In contrast, investment income consists of payments such as dividends and interest as well as realized capital gains.
What is the difference between ordinary gains and capital gains tax? ›
In a nutshell, capital gains taxes are applied to the profit made from selling a capital asset, such as stocks or real estate. Ordinary income taxes are applied to certain income and short-term capital gains.
Is social security considered ordinary income? ›
Generally, for combined incomes between $25,000 and $34,000 ($32,000 and $44,000 for joint filers), up to 50% of your Social Security benefits may be taxed as ordinary income, and if your combined income exceeds those thresholds, up to 85% is taxable.
Is interest income ordinary income or capital gains? ›
Most interest income is taxable as ordinary income on your federal tax return, and is therefore subject to ordinary income tax rates.
Do capital gains stack on top of ordinary income? ›
Remember that long-term capital gains stack on top of ordinary income. So, take your income minus the standard deduction and add your long-term capital gains and qualified dividends. This is the amount of money you pay in long-term capital gains taxes.
