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.
- The U.S. income tax system is progressive, with rates ranging from 10% to 37% of a filer’s yearly income. Rates rise as income rises.
- For tax purposes, short-term capital gains are treated as ordinary income on assets held for one year or less.
- Long-term capital gains are given preferential tax rates of 0%, 15%, or 20%, depending on your income level.
Your income tax percentage varies based on your specific tax bracket, and this depends 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 the 2021 and 2022 tax years, federal income tax percentages range from 10% to 37% of a person’s taxable yearly income after deductions.
The U.S. has 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 rates for a single filer in 2021, for example, are as follows:
- 10% on income up to $9,950
- 12% on income over $9,950
- 22% on income over $40,525
- 24% on income over $86,375
- 32% on income over $164,925
- 35% on income over $209,425
- 37% on income over $523,600
Thresholds are slightly higher for 2022:
- 10% on income up to $10,275
- 12% on income over $10,275
- 22% on income over $41,775
- 24% on income over $89,075
- 32% on income over $170,050
- 35% on income over $215,950
- 37% on income over $539,900
Capital Gains Tax
Tax rates on capital gains depend on how long the seller owned or held the asset. Short-term capital gains, for assets held for less than a year, are taxed at ordinary income rates. However, if you held an asset for more than a year, then more preferential long-term capital gains apply. These rates are 0%, 15%, or 20%—depending on your income level.
For 2021, a single filer pays 0% on long-term capital gains if their income is $40,400 or less. The rate is 15% if the person’s income is $445,850 or less, and 20% if it is over that amount.
For 2022, the thresholds are slightly higher: You pay 0% on long-term capital gains if you have an income of $41,675 or less; 15% if you have an income of $459,750 or less; and 20% if your income exceeds that figure.
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 determining your cost basis in the asset. If you purchase a property for $10,000, for example, and spend $1,000 on improvements, then your basis is $11,000. If you then sold the asset for $20,000, your gain is $9,000 ($20,000 minus $11,000).
Income Tax vs. Capital Gains Tax Example
Joe Taxpayer earned $35,000 in 2021. He pays 10% on the first $9,950 income and 12% on the income he earned beyond that. His total tax liability is $4,001 ($995 + $3,006).
If Joe sells an asset that produced a short-term capital gain of $1,000, then his tax liability rises by another $120 (i.e., 12% x $1,000). However, if Joe waits one year and a day to sell, then he pays 0% on the capital gain.
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.
How Are Capital Gains Taxed?
The rate of tax paid on realized capital gains depends on your total income, filing status, and the length of time you held the asset before selling. If you sell an asset after less than one year of ownership, the profit will count as ordinary income and be taxable based on your federal income tax bracket. Profits made on assets sold after lengthier holding periods are considered long-term capital gains and taxed separately at a lower rate.
What Is the Income Threshold for Capital Gains Tax?
For the 2021 tax year, individual filers won’t pay capital gains tax if their total taxable income is $40,400 or less. For 2022 returns, that threshold rises to $41,675.
Will Realized Capital Gains Push Me into a Higher Income Tax Bracket?
That depends on whether the capital gains are long- or short-term. The profit made on assets sold after a year may push you into a higher capital gains tax bracket but will not affect your ordinary income tax bracket as such gains are not treated as ordinary income.
Assets sold within a year receive less favorable treatment. Short-term gains count as ordinary income and, therefore, could push you into the next marginal ordinary income tax bracket.