Though any dollar in your wallet has the same purchasing power no matter how you earned it, not all types of income are created equal when it comes to income taxes. The federal tax code applies different tax rates to different types of income, so knowing the difference between an ordinary gain and a capital gain, and between long-term capital gains and short-term capital gains, can help you strategize with your investment decisions to save money when you file your taxes.
Understanding the Types of Income
The tax code breaks down income into two broad classifications: ordinary income and capital gains income. Ordinary income refers to any income that doesn’t qualify as a capital gain, such as wages, self-employment income, bonuses and interest.
Capital gains refer to profits you make from selling capital assets. Just about everything that you own and use for personal or investment purposes counts as a capital asset, such as your house, car, furniture, stocks and bonds. Certain capital gains are taxed at lower rates than ordinary income.
Long-Term Versus Short-Term Capital Gains
Not all capital gains are created equal, at least for income tax purposes. Capital gains are divided into two categories: short-term capital gains and long-term capital gains. Short-term capital gains refer to capital gains from the sale of assets you’ve owned for a year or less. Long-term capital gains refer to gains on assets that you’ve owned for a year or more. Long-term capital gains are taxed as preferential tax rates that are lower than the rates charged on a short-term gain.
When determining your holding period, if you received the asset as a gift from someone else, such as if your parents gave you shares of stock, you can count the amount of time the donor owned the property as part of your holding period. For example, if your parents owned the stock for five years and you sell it three months after you receive it, you can still treat the profits as a long-term capital gain because the combined holding period is more than one year. Proceeds from the sale of assets that you inherit from a decedent generally qualify for long-term capital gains treatment regardless of how long you and the decedent owned the property.
Ordinary Income Tax Rates
The tax brackets for ordinary income dropped significantly under the Tax Cuts and Jobs Act, passed at the end of 2017 and taking effect starting with the 2018 tax year. Previously, the tax brackets went as high as 39.6 percent for ordinary income.
For 2018, ordinary income for singles is taxed at 10 percent for the first $9,525, 12 percent for income between $9,526 and $38,700, 22 percent for income between $38,701 and $82,500, 24 percent for income between $82,501 and $157,500, 32 percent for income between $157,501 and $200,000, 35 percent for income between $200,001 and $500,000, and 37 percent for any income over $500,000.
For heads of household, ordinary income is taxed at 10 percent for the first $13,600, 12 percent for income between $13,601 and $51,800, 22 percent for income between $51,801 and $82,500, 24 percent for income between $82,501 and $157,500, 32 percent for income between $157,501 and $200,000, 35 percent for income between $200,001 and $500,000, and 37 percent for any income over $500,000.
For couples filing a joint return, ordinary income is taxed at 10 percent for the first $19,050, 12 percent for income between $19,051 and $77,400, 22 percent for income between $77,401 and $165,000, 24 percent for income between $165,001 and $315,000, 32 percent for income between $315,001 and $400,000, 35 percent for income between $400,001 and $600,000, and 37 percent for any income over $600,000. Married couples filing separately have tax brackets equal to half the size of couples filing jointly.
Tax on Earned Income
Some types of ordinary income are also considered earned income, which means income that you generated by working. So, ordinary income like wages, salaries, overtime, bonuses and self-employment income would count as earned income, but ordinary income like interest or short-term capital gains would be classified as unearned income.
Earned income is hit with two additional taxes, the Social Security tax and the Medicare tax, that unearned income isn’t subject to. For earned income working as an employee, these taxes are known together as FICA taxes or payroll taxes. For self-employment income, they are known together as self-employment taxes. The tax rate for both types of income is the same, but the way the tax is paid is different. As of 2018, the Social Security tax always totals 12.4 percent and the tax is only applied to the first $128,400 of your earned income – any earned income in excess of that amount isn’t subject to the Social Security tax. The Medicare tax is 2.9 percent on all income, plus an extra 0.9 percent for the Additional Medicare Tax on incomes over a certain threshold, depending on your filing status.
For employees, FICA taxes are withheld by your employer from your paycheck and both you and your employer each pay half of the tax. That means that instead of seeing 12.4 percent for the Social Security tax and 2.9 percent for the Medicare tax withheld from your paycheck, you’ll see 6.2 percent held back for the Social Security tax and 1.45 percent held back for the Medicare tax because the other half is paid by your employer.
For self-employment income, the entire self-employment tax is paid by the taxpayer because when you’re self-employed, you’re both the employer and the employee. However, to even the playing field for tax purposes, the self-employment tax is only applied to 92.35 percent of self-employment income and you can deduct the employer’s portion of the self-employment tax on your income tax return, to account for the fact that employees aren’t taxed on the 7.65 percent of the FICA taxes paid by their employer.
The Additional Medicare Tax is a little different. The tax applies to earned income over the threshold for your filing status: $250,000 for couples filing jointly, $200,000 for singles, heads of household, and widows and widowers with a qualifying child, and $125,000 if you’re married filing separately. Employers start withholding this tax when they pay an employee more than $200,000 in a calendar year, regardless of their filing status. If the tax is withheld but not owed, it will be refunded, while taxes owed but not withheld will be due when you file your tax return. This tax is borne entirely by the taxpayer, rather than being split between the employer and the taxpayer.
Long-Term Capital Gains Rate
The capital gains tax rates remained the same after the Tax Cuts and Jobs Act – the rates still range from 0 percent to 20 percent – but the size of the brackets has changed. Previously, the long-term capital gains rates were determined based on what tax rate would have applied if the capital gains were ordinary income. Now, the rate is determined by the total amount of income.
For single filers, long-term capital gains that, when added to the taxpayer’s ordinary income would be less than $38,600, aren’t taxed. Long-term capital gains between $38,600 and $425,800 are taxed at 15 percent and long-term capital gains in excess of $425,800 are taxed at 20 percent.
For taxpayers using the head of household filing status, long-term capital gains that, when added to the taxpayer’s ordinary income would be less than $51,700, aren’t taxed. Long-term capital gains between $51,700 and $452,400 are taxed at 15 percent and long-term capital gains in excess of $452,400 are taxed at 20 percent.
For married taxpayers who file a joint return, long-term capital gains that, when added to the taxpayer’s ordinary income would be less than $77,200, aren’t taxed. Long-term capital gains between $77,200 and $479,000 are taxed at 15 percent and long-term capital gains in excess of $479,000 are taxed at 20 percent.
For married taxpayers who file separate returns, long-term capital gains that, when added to the taxpayer’s ordinary income would be less than $38,600, aren’t taxed. Long-term capital gains between $38,600 and $239,500 are taxed at 15 percent and long-term capital gains in excess of $239,500 are taxed at 20 percent.
Understanding the Net Investment Income Tax
For higher-income taxpayers, all investment income, including interest, rental income and royalties, as well as long-term and short-term capital gains, is subject to the Net Investment Income Tax. This is an additional 3.8 percent tax on the smaller of all investment income or the amount by which the taxpayer’s adjusted gross income exceeds the threshold for his or her filing status – very closely reflecting the Additional Medicare Tax on earned income. For 2018, the threshold is $200,000 for singles and heads of household, $250,000 for couples filing jointly and widows or widowers with a qualifying child, and $125,000 if you’re married but filing separate returns.
For example, say you file your taxes as head of household and have $30,000 of net investment income. If your adjusted gross income is $213,000, you would only pay the net investment income tax on the last $13,000 of your net investment income, because you are only $13,000 over the threshold for the head of household filing status. However, if your adjusted gross income is $260,000, you would pay the net investment income tax on the entire $30,000 of investment income.
Calculating Net Capital Gains
The IRS allows you to offset your capital gains, and sometimes even ordinary income, with your capital losses. However, there are specific rules for the order in which gains are offset. In addition, you aren’t allowed to deduct capital losses on personal assets. For example, if you buy your car for $10,000, drive it for a few years for personal use, and then sell it for $6,000, you can’t claim a $4,000 loss.
First, you must use losses of the same type, short-term or long-term, to offset similar gains. Then, to the extent there are losses of one type in excess of similar gains, you can use those loss to offset other capital gains. Next, if you still have losses, you can offset up to $3,000 of your ordinary income with your capital losses. However, if you’re married filing separately, you’re limited to each spouse offsetting $1,500 each. Finally, if you still have additional capital losses, you can carry them forward to the next year.
For example, imagine that during the year you have $70,000 of ordinary income, $6,000 of long-term capital gains, $4,000 of long-term capital losses and a $9,000 short-term loss. You would first use your $4,000 of long-term capital losses to reduce your long-term capital gains to $2,000. Then, you can use $2,000 of your short-term capital loss to reduce your long-term capital gains to $0. Finally, you can use $3,000 to offset your ordinary income from $70,000 to $67,000. Finally, you can carry over the remaining $4,000 of short-term capital losses to the following year.