Ordinary Income and Capital Gains
When you are taking care of your personal finances, you’ll come across the terms “ordinary income” and “capital gains.” Most commonly, you will deal with them when working on your taxes and investments.
Ordinary income is a type of income earned by an individual that is taxed at the marginal income tax rates set by the IRS. In most cases, this is income earned through work.
Examples of ordinary income include wages, salaries, tips, commissions, and bonuses. Outside of work, ordinary income can come from interest income, rental income, unqualified dividends, and short-term capital gains (we will go deeper into this in a second).
A capital gain is simply the profit made on the sale of an asset. An asset can include things such as a stock, piece of land, real estate, boats, and even an entire business.
Within capital gains, there are short-term capital gains and long-term capital gains. Assets that are held for less than one year before being sold for a gain are considered short-term capital gains. Assets held for a year or longer for a gain are considered long-term capital gains.
If you buy an asset and later sell it for less than you bought it for, that is referred to as a capital loss.
Ordinary Income Examples
- Rental income
- Qualified dividends
- Short-term capital gains
Capital Gain Examples
Income earned for a gain from the sale of…
- Certain real estate
- Unqualified dividends
Taxes for Ordinary Income and Capital Gains
This distinction between short-term and long-term is important for tax purposes.
Short-term capital gains are taxed as ordinary income (as stated in the second paragraph).
Long-term capital gains are taxed at different rates than ordinary income. These rates are preferential to ordinary income rates because the three tax rates for long-term capital gains are 0%, 15%, and 20%.
The tax rates are set up favorably for long-term capital gains as an incentive for long-term investing.
As an investor, this can also protect you from making irrational short-term decisions. If you use the preferential tax rates as a motivator to invest long-term, you will be less likely to turn to day trading or sell of investments with when the market sways up and down.
It is well-known that markets trend up over time, so investing long-term will pay off at some point in time.
Tax Rate Comparison for 2020
Ordinary Income Tax Calculation Example
You are an employee at a company an receive a salary of $50,000. In addition to that, you earned a 5% commission on the $300,000 in business you brought in for your company. That gave you a $15,000 bonus.
On top of this, you rent out a unit in the duplex you own, which brings in $1000 a month in rental income.
Long-Term Capital Gains Tax Calculation Example
Now imagine you are an investor and bought $10,000 in stock just over a year ago. It turns out, you are a financial genius or extremely lucky because since then, your portfolio has grown to $30,000. Your gain is $20,000.
In reference to the ordinary income tax example, we will stick with the taxable income of $60,000. If you look at the tax brackets for long-term capital gains, you will see that a $60,000 taxable income amount will put you in the 15% bracket. Your $20,000 gain will be taxed at 15% for a tax bill of $3,000.
In this example above, you held the position for just over a year. Now, imagine that you sold your position after holding it for only 10 months. Your $20,000 gain would be taxed as ordinary income. The $20,000 gain would be taxed at 22% for a total tax bill of $4,400.
Compare this to the $3,000 bill if the gain was long-term. That is a $1,400 difference. As a percentage, your tax bill would be 47% higher when taxed as a short-term capital gain than it would be as a long-term capital gain.
Significance of Ordinary Income and Capital Gains
Okay, so why is this significant? Why are we talking about both ordinary income and capital gains in the same post?
These are great questions you are asking here. These two are significant in maneuvering through your taxes and investments in the most accurate and efficient way possible. “Efficiency” implies paying less taxes by thinking strategically.
Calculating total tax liability
Taxes are complex and vary depending on the type of income earned.
Your income, for the most part, will fall into the ordinary income or capital gains category. Understanding the difference between the two will allow you to define what portion of your income is ordinary income and what is a capital gain.
Once you identify the capital gains, you can further categorize the income into short-term and long-term. From there, you can accurately calculate your tax liability.
Strategizing with investments
The greater benefit of having knowledge on ordinary income and capital gains is to plan your investments and when you should buy or sell an asset.
Since long-term capital gains require an asset to be held for a year or longer, you might want to think twice before selling all your stocks that you have held for 11 months.
If you hold on for a month longer, you could greatly reduce the taxes on your gains. This logic can be applied to other assets as well. Making sure a capital gain is long-term is an easy way to reduce your tax liability on the gain.
The timing on when to buy and sell is critical to consider.
Ordinary income and capital gains are important for your personal finances. You will use your new knowledge on the two when dealing with your investments and taxes.
Knowing what is considered ordinary income, what is considered a capital gain, and what the associated tax rates are will help you in determining your tax bill to the IRS.
Additionally, you can plan your investments strategically. The type of income earned and the length of time you held an asset can mean the difference between substantially different tax rates.
Taxes can be confusing and get much more complex than the scope of this post. That said, this basic understanding on ordinary income and capital gains can prove to be very useful.
Always consult with a tax and/or accounting professional when coming to a final decision.