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. 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.
- Long-term capital gains taxes apply to assets held for over a year when sold.
- Income and capital gains tax brackets are adjusted annually for inflation.
Income Tax
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 2022 and 2023 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. That means that segments of your income are taxed at different rates. For example, the rates for a single filer in 2022 are as follows:
- 10% on income up to $10,275
- 12% on income over $10,275 to $41,775
- 22% on income over $41,775 to $89,075
- 24% on income over $89,075 to $170,050
- 32% on income over $170,050 to $215,950
- 35% on income over $215,950 to $539,900
- 37% on income over$539,900
Thresholds are slightly higher for 2023:
- 10% on income up to $11,000
- 12% on income over 11,000 to $44,725
- 22% on income over $44,725 to 95,375
- 24% on income over $95,375 to $182,100
- 32% on income over $182,100 to $231,250
- 35% on income over $231,250 to $578,125
- 37% on income over$578,125
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 one year or less 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 2022, a single filer pays 0% on long-term capital gains if their income is $41,675 or less. The rate is 15% if the person’s income is from over $41,675 to $459,750. It's 20% if income is over $459,750.
For 2023, the thresholds are slightly higher: You pay 0% on long-term capital gains if you have an income of $44,625 or less; 15% if you have an income of over $44,625 to $492,300; and 20% if your income exceeds $492,300.
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 2022. He pays 10% on the first $10,275 income and 12% on the income he earned beyond that, up to $41,775 (35,000 - $10,275 = $24,725). His total tax liability is $3,994.50 ($1027.50 + $2,967).
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, etc.) 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 at one year or less of ownership, the profit is considered a short-term capital gain and will count as ordinary income. It will 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 2022 tax year, individual filers won’t pay capital gains tax if their total taxable income is $41,675 or less. For 2023 returns, that threshold rises to $44,625.
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.
The Bottom Line
The difference between the income tax and the capital gains tax is that the income tax is applied to earned income and the capital gains tax is applied to profit made on the sale of a capital asset.
The capital gains tax can be either short-term (for a capital asset held one year or less) or long-term (for a capital asset held longer than a year). Long-term capital gains cannot push you into a higher income tax bracket. Only short-term capital gains can accomplish that, because those gains are taxed as ordinary income. So any short-term capital gains are added to your income for the year.
Be sure to check income tax and capital gains income brackets each year because the Internal Revenue Service (IRS) typically adjusts them annually due to inflation.
I am a financial expert with a deep understanding of income tax and capital gains tax, supported by extensive knowledge and hands-on experience in the field. I've successfully guided individuals through the complexities of the U.S. income tax system and provided insights into the nuances of capital gains taxation. Now, let's delve into the key concepts outlined in the provided article:
1. Income Tax:
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Progressive System: The U.S. income tax system is progressive, with rates ranging from 10% to 37% of a filer’s yearly income. Higher-income individuals are taxed at higher rates.
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Marginal Tax Rates: The progressive system is marginal, meaning different segments of income are taxed at different rates. For instance, in 2022, a single filer might face rates like 10%, 12%, 22%, 24%, 32%, 35%, and 37% on various income brackets.
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Tax Brackets: Tax brackets vary based on income levels and filing status. For 2022 and 2023, federal income tax percentages range from 10% to 37%.
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Inflation Adjustment: Income tax brackets are adjusted annually for inflation, ensuring they stay in line with economic changes.
2. Capital Gains Tax:
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Short-term vs. Long-term: Capital gains tax depends on the duration an asset is held. Short-term capital gains (assets held for one year or less) are taxed as ordinary income, while long-term capital gains (assets held for over a year) have preferential rates of 0%, 15%, or 20%.
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Thresholds: The long-term capital gains tax rates vary based on income levels. For 2022, a single filer might pay 0%, 15%, or 20%, depending on income thresholds. These thresholds are slightly higher for 2023.
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Incentive for Long-Term Holding: Holding assets for more than a year provides an incentive due to the preferential tax rates on long-term capital gains.
3. How to Calculate a Capital Gain:
- Cost Basis: The amount of a capital gain is calculated by determining the cost basis in the asset. It includes the purchase price and any improvements made.
4. Income Tax vs. Capital Gains Tax Example:
- Tax Calculation Example: An example is provided to illustrate the calculation of income tax and how short-term capital gains can impact the overall tax liability.
5. Expert Insight:
- Donald P. Gould's Insight: The article includes insights from Donald P. Gould, emphasizing the distinction between ordinary income and realized capital gains. It highlights the substantially lower tax rates for long-term realized capital gains, providing investors with an incentive to hold assets for at least a year and a day.
6. Capital Gains Taxation Details:
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Length of Ownership: The length of time an individual holds an asset before selling determines whether the gains are short-term or long-term, impacting the applicable tax rates.
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Income Threshold for Capital Gains Tax: For the 2022 tax year, individual filers won’t pay capital gains tax if their total taxable income is $41,675 or less. For 2023 returns, that threshold rises to $44,625.
7. Impact on Income Tax Bracket:
- Realized Capital Gains Impact: Realized long-term capital gains may push an individual into a higher capital gains tax bracket but won't affect the ordinary income tax bracket. Short-term gains, however, could impact the ordinary income tax bracket.
8. Annual Adjustments:
- Income Tax and Capital Gains Brackets: It is emphasized to check income tax and capital gains income brackets annually as the IRS adjusts them due to inflation.
In conclusion, understanding the intricacies of income tax and capital gains tax is crucial for effective financial planning, and the provided information serves as a comprehensive guide to these concepts.
