Income Tax. vs. Capital Gains Tax: An Overview

Income tax is paid on earnings from interest, dividends, employment, 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.

Income Tax

A person's income tax percentage is variable based on his specific tax bracket, and this is dependent on how much income he makes throughout the entire calendar year. Tax brackets also vary depending upon whether a person files as an individual or jointly with a spouse. For 2019, 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 lesser rates than higher income taxpayers on the presumption that the latter have a greater ability to pay more.

But the progressive system is marginal. Segments of income are taxed at different rates. For example, the first $9,700 of a single individual's income is taxed at 10 percent. Income from $9,701 to $39,475 is taxed at 12%. Income over $39,475 is taxed at 22%, up to an eventual top tax rate of 37% on income of $510,301 or more.

Capital Gains Tax

Capital gains tax is categorized as short-term or long-term, depending on how long the seller owned or held the asset.

A seller pays taxes at the long-term capital gains rate—0%, 15%, or 20% in 2019, depending upon his total income—when he holds an asset for longer than one year before sale. Assuming he's single, he would pay 0% if his total income was $39,375 or less, 15% if his income was $39,376 to $434,550, and 20% if his income was $434,551 or more.

A seller must pay taxes at the short-term capital gains rate if he holds the asset for just one year or less. This rate is the same as the ordinary income tax rate applied to his yearly taxable income.

Special Considerations

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. For example, you might purchase an asset for $10,000, 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 less $10,000 less $1,000.

Income Tax. vs. Capital Gains Tax Example

Joe Taxpayer's overall taxable income for the year after taking deductions is $80,000. This puts him in a top 22% tax bracket. He pays 10% on the first $9,700 ($970), 12% on his income up to $39,475 ($3,573), and 22% on his income up to $80,000 ($8,915.50), for a total income tax liability of $13,458.50. His effective income tax rate would be 16.8%—his total taxes divided by his total income.

The same equation would apply if Joe sold an asset for a short-term capital gain of $5,000, and this was included in his $80,000 income.

But if his ordinary income was $75,000, plus a long-term capital gain of $5,000 for a total of $80,000, he would be taxed differently. His income tax liability would drop to $12,358.50 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 $13,108.50. Joe saved himself $350 in total tax liability by holding his asset for at least one day longer than a year.

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. Longer periods of ownership are subject to their own tax rates, topping out at 20%—17% less than the top income tax rate.
  • Long-term capital gains are not included in taxable ordinary income. They're taxed separately at their own rates.

Advisor Insight

Donald P. Gould
Gould Asset Management, Claremont, CA

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. So 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.