What Is Ordinary Income Tax vs Capital Gain Tax?

May 25, 2022

This is our first article that we are doing on "How Is My Income Taxed?". Understanding how different types of income are taxed can be confusing and it is something we see pop up in our Free Facebook Group and Tax Minimization Program all the time.

There are three main types of income that we want to focus on and will be discussing over the coming weeks:

Before we get into the types of income we want to discuss a couple different types of taxes. 

What Is Ordinary Income Tax?

Ordinary income refers to any type of income taxed at the standard marginal tax rates. 

These, simply put, are just your normal income tax rates using the tax brackets (10%, 12%, 22%, 24%, 32%, 35%, and 37%). We discussed the 2022 rates along with a downloadable guide in last weeks article, 2022 Tax Rates and Resources.

Check out that article to find the brackets and rates for your specific scenario but just as a refresher here is what they are in 2022 for those that are filing as married filing jointly.

  • 10%: $20,550 and Under
  • 12%: $20,550 - $83,550
  • 22%: $83,550 - $178,150
  • 24%: $178,150 - $340,100
  • 32%: $340,100 - $431,900
  • 35%: $431,900 - $647,850
  • 37%: Over $647,850

Remember you pay taxes on the income in each respective bracket. As an example using the table from above, if you make $100,000 you will NOT pay 22% on all of that. You'll pay 10% on the first $20,550 and then $12% on $20,550 to $83,500 and then 22% on $83,500 to $100,000.

This is often a misunderstood piece. Simply put, by jumping into another tax bracket you are not hit with a higher tax on all of your income, just the portion of income that went into that next tax bracket.

What Is A Capital Gain or Loss?

When you own an asset or investment and sell it you either have a capital gain or loss.

To tell if it is a gain or loss you need to understand this idea of "basis". Your basis in an asset or investment is the amount you initially bought it for (or contributed) less any depreciation.

Lets go through a few examples:

Example 1

  • Assumptions
    • Bought Stock for $5,000
    • This would be your basis
  • Scenario 1
    • Sold for $4,000
    • You would have a $1,000 Capital Loss ($4,000 - $5,000)
  • Scenario 2
    • Sold for $6,000
    • You would have a $1,000 Capital Gain ($6,000 - $5,000)

Example 2

  • Assumptions
    • Bought a piece of equipment for $30,000
    • Depreciated $17,000
    • Your basis would be $13,000 ($30,000 - $17,000)
  • Scenario 1
    • Sold for $10,000
    • You would have a $3,000 Capital Loss ($10,000 - $13,000)
  • Scenario 2
    • Sold for $20,000
    • You would have a $7,000 Capital Gain ($20,000 - $13,000)

Basically if sale price is greater than basis you have a capital gain and if sale price is less than basis you have a capital loss.

What Are Capital Gain Tax Rates?

Capital gains have a much more favorable tax treatment than ordinary income. There are two buckets of capital gain taxes:

  • Short-Term Capital Gain: Held for 1 year or less
  • Long-Term Capital Gain: Held for more than 1 Year

Each bucket is taxed differently:

  • Short-Term Capital Gain
    • Taxed at Ordinary Income Tax Rates 
  • Long-Term Capital Gain
    • Taxed at 0%, 15%, or 20%, depending on your income.
    • You can find the 2022 rates here.

As you can tell from above, the IRS rewards you for holding on to assets. As an example if you purchase a stock and hold it for 6 months and then sell it, you'll be taxed at ordinary income tax rates. If you would have instead held on to it for 18 months you would have paid long term capital gain tax rates.

One thing to note is that there are a couple exceptions to the capital gain tax rates:

  • Collectibles Held > 1 Year: Taxed at 28%
  • Section 1202 Qualified Small Business Stock Held > 5 Years: Taxed at 28%
  • Unrecaptured Section 1250 Gain Held > 1 Year: Taxed at 25%

If you're facing a potential large capital gain, you may want to look into advanced planning before making the sale, this would be a good time to reach out to us or join our Tax Minimization Program.

How Are Capital Losses Treated?

We talked about what happens if you sell an asset for a gain but what happens if you sell it for a loss? Capital losses can offset capital gains.

Losses must first be used to offset gains of the same type (example: a long term capital loss will offset a long term capital gain first) but if losses of one type are more than the gains of that type then you can apply the rest to the other type.

Traditionally we would try to avoid using a short term capital loss to offset a long term gain.

If you have more capital losses in a year than capital gains, the maximum capital loss you can take over and above capital gains in a year is $3,000. The remaining would be carried forward.

As an example, lets say you have a capital gain of $10,000 but have a capital loss of $40,000. You would be able to offset the $10,000 capital gain entirely but then would only be able to take an additional capital loss of $3,000 with the remaining $27,000 capital loss being carried forward.

What Other Taxes Are There? 

  • Social Security and Medicare Taxes (aka FICA aka Payroll Taxes)
  • Self Employment Taxes
  • Kiddie Tax: A special tax at your marginal rate on unearned income over $1,150 paid to children under age 19 (or dependent full-time students under age 24).
  • Alternative Minimum Tax: A parallel tax intended to stop “the rich” from escaping tax entirely.
  • Net Investment Income Tax (NIIT): A 3.8% tax on “investment income” (interest, dividends, capital gains, rents, royalties, and annuities) for taxpayers earning above $200,000 ($250,000 for joint filers).
  • State and Local Taxes: Don't forget about the various taxes applied based on where you live and earned money.
  • Corporate Tax
  • Sales and Use Tax
  • Excise Tax
  • Estate and Trust Taxes: Check out our article here, How Are My Assets Taxed When I Die?
  • Property/Real Estate Taxes

Be sure to check out our other articles on how your income is taxed, links to those are at the top of this article!

As always if you are looking at how to lower your taxes, check out our Tax Minimization Program where we deep dive into strategies to ensure you're paying the least amount in taxes as legally possible while giving you access to our team for those questions that pop up along the journey!


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