Ordinary Income Tax vs. Capital Gains Tax

It’s tax season, so we have been talking about different types of tax with clients a lot lately. Although ordinary income tax and capital gains tax are not the only types of taxes that exist, they are the two we deal with the most. So, what are these two types of taxes, how do they work and when do they apply? Let’s dive in.

Ordinary Income Tax: This is what people are talking about when they talk about income tax. This is a tax that is applied to earned income from working, though other types of income fall into this category as well.

How does Ordinary Income Tax Work? In the United States, we have a progressive tax system. As your income goes up, so does your tax rate. In 2024 these rates range from 10% to 37% for federal income tax. State and local governments can add income tax as well, but for simplicity, I am just going to focus on federal taxes.

A common misconception is that taxpayers pay their top marginal rate on all their taxable income, but this is not true. To take a simplistic example, if a married couple made $150,000 in taxable income in 2024 from working, they would be in the 22% marginal bracket. However, they would not owe 22% of the entirety of that income. They would pay 10% on the first $23,199, 12% on the income between $23,200 to $94,299, and 22% on their remaining earned income.

What is Taxed at Ordinary Rates? A lot. This is not an all-encompassing list, but here are the most common types of income that would be taxed at ordinary income rates.

  • Wages from working
  • Bonuses
  • 1099 income from self-employment, freelancing, etc.
  • Interest (CDs, taxable bonds, loans)
  • Ordinary dividends (Qualified dividends are taxed at more favorable capital gains rates)
  • Short-term investment gains (held for less than a year)
  • Retirement account distributions (IRAs, 401(k)s, SEPs, etc.)
  • Annuity payments (excluding your basis)
  • Pension payments
  • Real estate investment income
  • Lottery and Gambling winnings
  • Social Security Income (although not 100% is taxed)
  • And more…

As you can see there are a lot of different types of income that are subject to ordinary income rates. Ordinary income rates are higher than the more favorable capital gains treatment. So, what is the deal with capital gains tax?

Capital Gains Tax – Investments that have been held for a year or more and sold for a profit are taxed at more favorable capital gains rates. Only the gain above the basis is taxed, not the entire value of the sale. This applies to stocks, bonds, real estate, businesses, etc. Gains from collectibles notably do not get capital gains treatment. They are taxed at a flat 28% rate.

The rates for capital gains in 2024 are 0%, 15%, and 20% depending on your income. Single filers earning less than $47,025, will pay 0% capital gains tax. If your income is between $47,026 and $518,900 you are in the 15% bracket. Income above $518,901 is in the 20% capital gains bracket. For anyone who is married and files a joint tax return, the 0% bracket is for those earning less than $94,050. Married folks with income between $94,051-$583,750 fall into the 15% capital gains bracket. Couples who make more than $583,751 will pay 20% capital gains rates.

Capital gains rates are more favorable than ordinary income rates, so a good tax planning technique is to hold investments long enough to enjoy these lower rates when possible. This can be a mistake that novice investors and traders make when managing their own accounts, and it can be costly on the tax side.

Note: Long-term capital gains won’t push you into a higher ordinary income tax bracket, but they can push you into a higher capital gains bracket. Short-term capital gains can push you into a higher ordinary income tax bracket.

All things tax-related can get complicated, so always ask your accountant or financial advisor if you have any questions about your specific situation.