Ordinary income and capital gains are two types of income that individuals and businesses can earn, but they are subject to different tax treatments. Understanding the differences between ordinary income and capital gains, as well as how they are taxed, is essential for effective tax planning and investment strategies. This article explores the key distinctions between ordinary income and capital gains, the tax rates applied to each, and how to manage both types of income for optimal tax efficiency.
1. What is Ordinary Income?
Ordinary income refers to the income earned by individuals or businesses from their regular activities, such as wages, salaries, interest, dividends, and business profits. Ordinary income is taxed at the individual’s or business’s regular income tax rates, which can vary based on the income level and filing status.
A. Sources of Ordinary Income
- Wages and Salaries: Income earned through employment is considered ordinary income. This includes the wages, salary, and bonuses that employees receive.
- Interest Income: Income earned from interest on savings accounts, bonds, or loans is considered ordinary income and is taxed at regular income tax rates.
- Dividend Income: Non-qualified dividends, or ordinary dividends, are taxed as ordinary income. These are typically paid by companies that do not meet the requirements for qualified dividend status.
- Rental Income: Income earned from renting property is considered ordinary income and is taxed at the individual’s marginal tax rate.
- Self-Employment Income: Income earned by self-employed individuals, such as freelancers, independent contractors, or business owners, is treated as ordinary income and subject to self-employment tax.
B. Tax Rates on Ordinary Income
- Progressive Tax Rates: Ordinary income is taxed according to a progressive tax system, where tax rates increase as income rises. The rates in the U.S. for 2023 range from 10% to 37%, depending on the income level and filing status.
- Additional Taxes: Some ordinary income, such as wages, is also subject to payroll taxes, including Social Security and Medicare taxes. Self-employed individuals pay both the employer and employee portions of these taxes.
2. What is Capital Gains Income?
Capital gains refer to the profits made from the sale of investments, such as stocks, bonds, real estate, or other capital assets. Capital gains are realized when an asset is sold for more than its purchase price. The tax treatment of capital gains depends on how long the asset is held before sale.
A. Types of Capital Gains
- Short-Term Capital Gains: If an asset is sold within one year of purchase, the resulting profit is considered short-term capital gain. Short-term capital gains are taxed as ordinary income, subject to the individual’s tax bracket.
- Long-Term Capital Gains: If an asset is held for more than one year before being sold, the profit is considered a long-term capital gain. Long-term capital gains are generally taxed at preferential rates that are lower than ordinary income tax rates.
B. Tax Rates on Capital Gains
- Short-Term Capital Gains: Short-term capital gains are taxed as ordinary income, meaning they are subject to the same tax rates as wages, salaries, and other forms of ordinary income.
- Long-Term Capital Gains: Long-term capital gains are taxed at preferential rates, typically 0%, 15%, or 20%, depending on the taxpayer’s income level and filing status. For higher-income individuals, there may be an additional 3.8% Net Investment Income Tax (NIIT) on long-term capital gains.
- Example: If you sell a stock that you’ve held for more than a year and make a profit of $10,000, you may pay 15% in taxes on that gain (depending on your income level), rather than the ordinary income tax rate that would apply to wages.
C. Tax Exemptions and Special Cases for Capital Gains
- Primary Residence Exemption: Under certain conditions, individuals can exclude up to $250,000 ($500,000 for married couples filing jointly) of capital gains from the sale of their primary residence, provided they meet the ownership and use tests.
- Capital Losses: If you sell an asset at a loss, you can use that loss to offset any capital gains you’ve realized in the same tax year. If your losses exceed your gains, you can deduct up to $3,000 of the loss from your ordinary income each year, with any remaining losses carried forward to future years.
3. Key Differences Between Ordinary Income and Capital Gains
Although both ordinary income and capital gains are types of taxable income, they are treated differently under the tax code. Here are the key differences:
A. Tax Rates
- Ordinary Income: Ordinary income is subject to progressive tax rates, with rates ranging from 10% to 37% in the U.S. Taxpayers in higher income brackets pay a higher percentage of their income in taxes.
- Capital Gains: Short-term capital gains are taxed at ordinary income rates, while long-term capital gains benefit from lower preferential rates (0%, 15%, or 20%, depending on income levels).
B. Holding Period
- Ordinary Income: Ordinary income is earned through regular sources, such as wages or interest, and is not dependent on how long an asset is held.
- Capital Gains: Capital gains are based on the sale of assets, and the tax treatment depends on whether the asset is held for more or less than one year.
C. Tax Planning Strategies
- Ordinary Income: Taxpayers can reduce ordinary income tax liability by contributing to tax-deferred retirement accounts, utilizing deductions and credits, and taking advantage of tax-free income sources (e.g., municipal bonds).
- Capital Gains: Taxpayers can reduce capital gains taxes by holding investments for longer than one year to qualify for long-term capital gains rates, offsetting gains with losses (tax loss harvesting), and utilizing tax-advantaged accounts like IRAs and 401(k)s to shelter capital gains from taxation.
4. Tax Planning Considerations for Ordinary Income and Capital Gains
Taxpayers can use several strategies to manage both ordinary income and capital gains in a tax-efficient manner. Here are some key tax planning considerations:
A. Tax Deferral Strategies
- Retirement Accounts: Contributing to tax-deferred accounts like IRAs, 401(k)s, and other retirement plans allows taxpayers to reduce taxable income in the current year while deferring taxes on investment gains until retirement. For Roth accounts, both income and gains are tax-free upon withdrawal under qualifying conditions.
- Deferred Compensation Plans: Certain employer-sponsored compensation plans allow employees to defer income to future years, potentially lowering current-year taxable income and postponing taxes until the income is received.
B. Tax Loss Harvesting
- Offsetting Capital Gains: Tax loss harvesting involves selling investments that have declined in value to offset realized capital gains. This can reduce the taxable amount of capital gains and help minimize tax liability.
- Example: If you realize $5,000 in capital gains from the sale of stocks but have $3,000 in capital losses from other investments, you can use the losses to offset the gains, effectively lowering your taxable capital gains to $2,000.
C. Holding Period for Long-Term Capital Gains
- Strategy: To take advantage of long-term capital gains tax rates, investors should hold investments for more than one year before selling. This simple strategy can result in significant tax savings on gains from investments like stocks and real estate.
- Example: Selling a stock after holding it for 14 months rather than 10 months allows the investor to benefit from lower long-term capital gains rates instead of the higher short-term rates.
5. Understanding the Tax Treatment of Ordinary Income and Capital Gains
Ordinary income and capital gains are two important sources of income, but they are taxed differently. Ordinary income is subject to progressive tax rates, while capital gains may be eligible for preferential tax treatment, particularly if the asset is held for over a year. Understanding the tax differences and strategic ways to manage both types of income is essential for minimizing tax liability and maximizing after-tax returns.
By using tax planning strategies such as holding investments for the long term, utilizing tax-deferred accounts, and engaging in tax loss harvesting, individuals can optimize their tax position and ensure that they are taking full advantage of the tax laws that apply to their income.