Ordinary Income Taxation vs. Capital Gains Taxation

financial planning for attorneys financial planning for entrepreneurs financial planning for retirement Mar 05, 2020

by Glenn J. Downing, MBA, CFP®

In this post I’m tackling a tax topic: The difference between ordinary income taxation and capital gains taxation. What’s the difference and why is it important to know? One word: taxes.

The IRS taxes your income, as you know, but it also taxes profits. If you buy a stock for, say, $100/share, and then sell it for $120/share, you have a $20 gain which is taxable. The original $100 purchase price is what’s called your basis in the stock. Basis is increased by sales taxes paid on the item, any legal fees associated with its purchase – even inbound freight costs. When you sell at a profit, you want your basis to be as high as possible, to reduce your taxes on the gain.

A Capital Gains Taxation Example

Let’s look at how that $20 gain is taxed. It all depends upon your holding period for the asset – how long you owned it. If you held the asset for more than one year, then it is taxed at a capital gains rate. That rate is 0% for those in the 10% and 12% marginal brackets, 20% for those in the very top 37% marginal bracket, and 15% for everyone else (2020).

If held for less than one year, then the gain is taxed as ordinary income. The gain gets added to your wages, business income, real estate income, and so forth, and is then taxed at your marginal rate. Usually the long term capital gains rate will be the lower of the two rates.

An Ordinary Income Taxation Example

Let’s continue with that stock example. Say I am married and in a 24% marginal tax bracket. This means that the next dollar I earn gets taxed at 24%. If I hold the stock for more than one year before selling it, I have a long term capital gain, taxed at 15%. BUT – if I held the stock for less than a full calendar year when selling, then I have a short term capital gain, which is taxed at my ordinary income rate of 24%.

Now look at the difference. Under capital gains taxation, that $20 gain is taxed at 15%, so I net $17 after taxes. Under ordinary income taxation, that $20 is taxed at my marginal 24% rate, so I net only $15.20. Consequently, if we’re talking trades in the tens of thousands of dollars, the difference can be enormous. Clearly the tax code encourages investors to hold for the long-term.

Here’s the Trade-off

What assets produce capital gains, and what assets produce ordinary income?

Capital assets are those which are held for a period of time, are subject to market conditions, and are sold at a profit or loss. Think stocks, bonds, mutual funds, real estate, and business interests.

Assets which produce interest type income do not get capital gains treatment. These are bank accounts, annuity payments, pension payments, and traditional IRA distributions. Knowing this, you can see the trade-off involved in retirement accounts: one gives up the more favorable capital gains treatment during the accumulation years in exchange for deferral of taxation on all growth in the asset (big advantage) for ordinary income treatment upon distribution down the road (disadvantage).

I hope this is helpful. Look for my next blog piece entitled, Step Up in Basis. It is a companion to this one, and picks up from here to discusses the differences in taxation of capital assets and ordinary income assets that you bequeath at death.

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