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.

Key Takeaways

  • The U.S. uses a progressive income tax system with rates ranging from 10% to 37% of a person’s yearly taxable income. Rates increase as income rises.
  • Capital gains tax is imposed at these same rates for assets owned for one year or less before sale (so-called short-term capital gains).
  • Long-term capital gains are not included in taxable ordinary income. They’re taxed separately at their own rates, topping out at 20%, which is 17% less than the top income tax rate.

Income Tax

Your income tax percentage is variable based on your specific tax bracket, and this is dependent on how much income you make throughout the entire calendar year. Tax brackets also vary depending upon whether you file as an individual or jointly with a spouse. For 2019 and 2020 federal income tax percentages are between 10% and 37% of a person’s taxable yearly income after deductions.

The U.S. uses a progressive tax system. Lower income individuals are taxed at lower rates than higher income taxpayers on the presumption that those with higher incomes have a greater ability to pay more.

However, the progressive system is marginal. Segments of income are taxed at different rates. The first $9,700 of a single individual’s income, for example, is taxed at 10% in 2019 (up to $9,875 in 2020). In 2019, income over $9,700 and up to $39,475 ($9,876 to $40,125 in 2020) is taxed at 12%. Income over $39,475 and up to $84,200 ($40,125 to $85,525 in 2020) is taxed at 22%. Subsequent tax rates are 24%, 32%, 35%, and a top rate of 37% on income greater than $510,300 ($518,400 in 2020).

Capital Gains Tax

Capital gains tax rates depend on how long the seller owned or held the asset—either short-term or long-term. Short-term capital gains, for assets held for less than a year, are taxed at the same rates as ordinary income. You pay taxes at the long-term capital gains rate—0%, 15%, or 20% in 2019 and 2020, depending upon your total income and filing status—when you hold an asset for longer than one year before sale. For tax year 2019, assuming you are single, you would pay 0% if your total income was $39,375 or less ($40,000 in 2020), 15% if it was more than $39,375 and up to $434,550 (up to $441,500 in 2020), and 20% if it was more than $434,550 (over $441,500 in 2020).

An individual must pay taxes at the short-term capital gains rate, which is the same as the ordinary income tax rate, if an asset is held for one year or less.

How to Calculate a Capital Gain

The amount of a capital gain is arrived at by subtracting the sales price, less depreciation, plus costs of sale and improvements (called your basis) from the sales price. You might purchase an asset for $10,000, for example, claim no depreciation during your period of ownership, and invest an additional $1,000 in getting it sold for a sales price of $20,000. Your gain is $9,000 ($20,000 minus $10,000 minus $1,000).

Income Tax. vs. Capital Gains Tax Example

After taking deductions, Joe Taxpayer’s overall taxable income for the year 2020 is $80,000. This puts him in a top 22% tax bracket. He pays 10% on the first $9,875 ($987.50), 12% on his income up to $40,125 ($3,630), and 22% on his income up to $80,000 ($8,772.50), for a total income tax liability of $13,390. His effective income tax rate would be 16.7% (his total taxes divided by his total income).

Now let's look at what happens if Joe sold an asset for a short-term capital gain of $5,000, and this was included in his $80,000 income. If his ordinary income is $75,000, plus a long-term capital gain of $5,000 for a total of $80,000, he is taxed differently. His income tax liability drops to $12,290 based on income tax on $75,000. He would owe an additional $750 on his $5,000 in long-term capital gains for a total income and capital gains tax bill of $13,040. Thus Joe saves himself $350 in total tax liability by holding his asset for at least one day longer than a year.

Advisor Insight

Donald P. Gould
Gould Asset Management, Claremont, Calif.

The IRS separates taxable income into two main categories: “ordinary income” and “realized capital gain.” Ordinary income includes earned wages, rental income, and interest income on loans, CDs, and bonds (except for municipal bonds). A realized capital gain is the money from the sale of a capital asset (stock, real estate) at a price higher than the one you paid for it. If your asset goes up in price but you do not sell it, you have not “realized” your capital gain and therefore owe no tax.

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.