Income tax is paid on earned income, interest, dividends, royalties, or self-employment in the form of services, money, or goods. Capital gains tax is paid on income from the sale or exchange of an asset, such as a stock or property classified as an equity asset.
Income Tax
The income tax rate varies by specific tax category and depends on your income during the calendar year. Tax rates also vary depending on whether you are filing as an individual or with your spouse. For fiscal years 2021 and 2022, federal income tax rates range from 10% to 37% of an individual's annual taxable income after deductions.
The United States has a progressive tax system. Low-income people pay less tax than high-income taxpayers, assuming that higher-income taxpayers are able to pay more.
However, the progressive system is marginal. Income segments are taxed at different rates. The single taxpayer rate in 2021, for example, is as follows:
10% on income up to $9,950
12% on income over $9,950
22% for income over $40,525
24% for income over $86,375
32% for income over $164,925
35% for income over $209,425
37% for income over $523,600
The limits 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
A capital gain tax rate depends on how long the seller has owned or held the asset. Short-term capital gains on assets held for less than one year are taxed at normal rates. However, higher long-term preferred capital gains apply if you have been in business for more than a year. These rates are 0%, 15%, or 20%, depending on your income level.
For 2021, a single taxpayer pays 0% long-term capital gain if their income is $40,400 or less. The fee is 15% if the person's income is $445,850 or less and 20% if it exceeds this amount.
For 2022, the limits are slightly higher: pay 0% on long-term capital gains if you have an income of $41,675 or less; 15% if you have an income of $459,750 or less, and 20% if your income exceeds this amount.
A person must pay tax at the short-term capital gains rate, which is the same as the usual income tax rate if the asset is held for one year or less.
How to Calculate a Capital Gain
The value of a capital gain is determined by determining its cost relative to the asset. If you buy a property for $10,000, for example, and spend $1,000 on improvements, your base is $11,000. If you later sell the asset for $20,000, your profit would be $9,000 ($20,000 minus $11,000).
Example of Income Tax vs. Capital Gains Tax
John earned $35,000 in 2021. He pays 10% of the first $9,950 in earnings and 12% of the earnings that follow. His total tax debt is $4,001 ($995 + $3,006).
If John sells an asset that has a short-term capital gain of $1,000, his tax liability will increase by an additional $120 (i.e., 12% x $1,000). However, if John waits a year and a day to sell, he pays 0% of the capital gain.
The Internal Revenue Services separates taxable income into two primary categories: "ordinary income" and "realized capital gains." Ordinary income includes wages, rental income, and interest income on loans, certificates of deposit, and bonds (excluding municipal bonds). A realized capital gain is the revenue from the sale of capital (stocks, real estate) at a higher price than that paid. If your property appreciates in value, but you do not sell it, you have not "realized" the capital gain and therefore do not owe taxes.
The most significant thing to understand is that long-term capital gains are taxed significantly lower than regular income. This means that investors have a strong incentive to hold valued assets for at least a year and a day, calling them long-term and at the base rate.
How are capital gains taxed?
The tax rate you pay for capital gains depends on your total income, filing status, and how long you held the asset before selling it. If you sell your asset after less than a year of ownership, the earnings will be considered regular income and taxed in your federal tax class. Capital gains on assets sold after longer holding periods are considered long-term capital gains and are taxed separately at a lower rate.
What is the income level for capital gains tax?
For 2021, individual taxpayers will not pay capital gains tax if their total taxable income is $40,400 or less. For 2022 returns, this threshold increases to $41,675.
Will realized capital gains move me into a higher tax bracket?
It depends on whether the capital gains are long-term or short-term. Income from property sold after one year may move you to a higher capital gains tax class, but this will not affect your ordinary income tax class as such income is not treated as ordinary income.
Goods sold within the year receive less favorable treatment. Short-term income is considered ordinary income and may place you in the next marginal category of ordinary income tax.
Summary
The US income tax system is progressive, with rates ranging from 10% to 37% of the taxpayer's annual income. Rates increase as revenue increases.
For tax reasons, short-term capital gains are treated as ordinary income from assets held for one year or less.
Long-term capital gains receive preferential shares of 0%, 15%, or 20%, depending on income level.
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