The Difference Between Income Tax and Capital Gains Tax

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The Difference Between Income Tax and Capital Gains Tax

Earnings from work, interest, dividends, royalties, or self-employment, whether in the form of services, money, or property, are subject to income tax. The capital gains tax is levied on income derived from the sale or exchange of a capital asset, such as a stock or property.

Key Takeaways

  • The income tax system in the United States is progressive, with rates ranging from 10% to 37% of a filer’s annual income. As income grows, so do interest rates.
  • Short-term capital gains on assets held for one year or less are taxed as regular income.
  • Long-term capital gains are taxed at a lower rate of 0%, 15%, or 20%, depending on your income level.

Income Tax

Your income tax percentage varies depending on your tax band, and it is calculated based on your total income for the calendar year. The tax rates also differ depending on whether you file as an individual or jointly with your spouse. For the tax years 2021 and 2022, federal income tax percentages vary from 10% to 37% of taxable annual income after deductions.

The United States has a progressive tax system. Lower-income taxpayers are taxed at lower rates than higher-income taxpayers on the assumption that higher-income taxpayers have a better capacity to pay more.

The progressive system, on the other hand, is marginal. Various income levels are taxed at different rates. In 2021, for example, the rates for a single filer are as follows:

  • 10% on income up to $9,950
  • 12% on income over $9,950
  • 22% on income over $40,525
  • 24% on income over $86,375
  • 32% on income over $164,925
  • 35% on income over $209,425
  • 37% on income over $523,600
  Back Taxes

Thresholds are slightly higher for 2022:

  • 10% on income up to $10,275
  • 12% on income over $10,275
  • 22% on income over $41,775
  • 24% on income over $89,075
  • 32% on income over $170,050
  • 35% on income over $215,950
  • 37% on income over$539,900

Capital Gains Tax

Capital gain tax rates are determined by how long the seller owned or kept the item. Short-term capital gains are taxed at ordinary income rates on assets held for less than a year. Long-term capital gains are more favourable if you own an asset for longer than a year. Depending on your income level, these rates are 0%, 15%, or 20%.

If a single filer’s income is $40,400 or less in 2021, they pay no tax on long-term capital gains. If the person’s income is $445,850 or less, the rate is 15%; otherwise, the rate is 20%.

The standards for 2022 are somewhat higher: Long-term capital gains are taxed at 0% if your income is $41,675 or less; 15% if your income is $459,750 or less; and 20% if your income exceeds that sum.

If an asset is kept for one year or less, a person must pay taxes at the short-term capital gains rate, which is the same as the regular income tax rate.

How to Calculate a Capital Gain

The amount of a capital gain is calculated by calculating your cost basis in the asset. If you buy a home for $10,000 and subsequently spend $1,000 on upgrades, your basis is $11,000. If you sell the asset for $20,000, your profit is $9,000 ($20,000 minus $11,000).

  Understanding Tax Brackets, With Examples and Their Pros and Cons

Income Tax vs. Capital Gains Tax Example

Joe Taxpayer will make $35,000 in 2021. He pays 10% on the first $9,950 in earnings and 12% on earnings over that. The entire amount of his tax due is $4,001 ($995 + $3,006). If Joe sells an item that generated a $1,000 short-term capital gain, his tax burden increases by $120 (i.e., 12% x $1,000). Joe, on the other hand, pays 0% on the capital gain if he waits one year and a day to sell.

Advisor Insight

Donald P. GouldGould Asset Management, Claremont, Calif.

The Internal Revenue Service divides taxable income into two categories: “ordinary income” and “realized capital gain.” Earned earnings, rental income, and interest income from loans, CDs, and bonds are all examples of ordinary income (except for municipal bonds).A realized capital gain is the amount of money gained through the sale of a capital asset (stock, real estate) at a greater price than you paid for it. If the value of your asset rises but you do not sell it, you have not “realized” your capital gain and hence owe no tax.

The most essential thing to remember is that long-term realized capital gains are taxed at a far lower rate than regular income. This implies that investors have a strong incentive to keep valued assets for at least a year and a day in order to qualify for the preferred rate.

How Are Capital Gains Taxed?

The tax rate on realized capital gains is determined by your total income, filing status, and the period you owned the item before selling. If you sell an asset after less than a year, the profit is considered regular income and is taxed according to your federal income tax rate. Profits on assets sold after longer holding periods are classified as long-term capital gains and are taxed separately at a reduced rate.

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What Is the Income Threshold for Capital Gains Tax?

Individual filers will not have to pay capital gains tax if their total taxable income is $40,400 or less in the 2021 tax year. That threshold climbs to $41,675 for 2022 returns.

Will Realized Capital Gains Push Me into a Higher Income Tax Bracket?

This is determined by whether the capital gains are long-term or short-term. Profit on assets sold after a year may drive you into a higher capital gains tax band, but it will have no effect on your regular income tax rate since such gains are not considered ordinary income.

Assets sold within a year are treated less favorably. Short-term profits are treated as regular income and may push you into the next marginal ordinary income tax band.

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