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
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 ordinary income and capital gains? ›
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.
Which tax rate is higher ordinary income or capital gains? ›
The most important thing to understand is that long-term realized capital gains are subject to a substantially lower tax rate than ordinary income. This means that investors have a big incentive to hold appreciated assets for at least a year and a day, qualifying them as long-term and for the preferential rate.
What is the difference between ordinary losses and capital gains? ›
An ordinary loss is mostly fully deductible in the year of the loss, whereas capital loss is not. An ordinary loss will offset ordinary income on a one-to-one basis. A capital loss is strictly limited to offsetting a capital gain and up to $3,000 of ordinary income.
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 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.
At what age do you not pay capital gains? ›
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.
Can capital gains losses offset ordinary income? ›
If you don't have capital gains to offset the capital loss, you can use a capital loss as an offset to ordinary income, up to $3,000 per year. If you have more than $3,000, it will be carried forward to future tax years." Here are the steps to take when it comes to tax filing season.
What is the exemption for capital gains tax? ›
When does capital gains tax not apply? If you have lived in a home as your primary residence for two out of the five years preceding the home's sale, the IRS lets you exempt $250,000 in profit, or $500,000 if married and filing jointly, from capital gains taxes.
What is not included in ordinary income? ›
For individuals, ordinary income usually consists of the pretax salaries and wages they have earned. In a corporate setting, ordinary income comes from regular day-to-day business operations, excluding income gained from selling capital assets.
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.
What counts as income for capital gains tax? ›
Any time you sell an investment for more than you bought it, you potentially create a taxable capital gain. Capital gains can apply to almost any investment that is sold at a profit, such as stocks, bonds, real estate, precious metals, options contracts, or even cryptocurrency.
Can you offset capital gains with ordinary income? ›
You can use capital losses to offset capital gains during a tax year, allowing you to remove some income from your tax return. You can use a capital loss to offset ordinary income up to $3,000 per year If you don't have capital gains to offset the loss.
Do capital gains count towards ordinary income brackets? ›
Your capital gains tax isn't included as part of your total income tax requirement but might be taxed similarly. The income tax is what is referred to within the tax brackets above. A short-term capital gains tax is taxed at the same tax brackets, but long-term capital gains are taxed at 0%, 15% or 20%.
What income qualifies as capital gains? ›
What are capital gains? Any time you sell an investment for more than you bought it, you potentially create a taxable capital gain. Capital gains can apply to almost any investment that is sold at a profit, such as stocks, bonds, real estate, precious metals, options contracts, or even cryptocurrency.
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.
