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. tax system is progressive with rates ranging from 10% to 37% of a filer’s yearly income. Rates rise as income rises.
  • Short-term capital gains are treated as ordinary income on assets held for one year or less.
  • Long-term capital gains are given preferential rates of 0%, 15% or 20%, depending on your income level.

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. For example, the rates for a single filer in 2019 are as follows:

  • 10% on income up to $9,700
  • 12% on income over $9,700
  • 22% on income over $39,475
  • 24% on income over $84,200
  • 32% on income over $160,725
  • 35% on income over $204,100
  • 37% on income over $510,300

Thresholds are slightly higher for 2020:

  • 10% on income up to $9,875
  • 12% on income over $9,875
  • 22% on income over $40,125
  • 24% on income over $85,525
  • 32% on income over $163,300
  • 35% on income over $207,350
  • 37% on income over $518,400

Capital Gains Tax

Capital gains tax rates 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 upon on your income level.

For 2019, a single filer pays 0% on long-tern capital gains if that person's income is $39,375 or less. The rate is 15% if the person's income falls under $434,550 and 20% if it is over that amount.

For 2020, the thresholds are slightly higher: you pay 0% on long-term capital gains if you have income of $40,000 or less; 15% if you have income of $441,450 or less; and 20% if your income is greater than $441,450.

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. For example, if you purchase a property for $10,000 and spent $1,000 on improvements, 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 2019. He pays 10% on the first $9,700 income and 12% on the income that comes after that. His total tax liability is $4,006.

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.

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.