Here's something I don't love to admit: I did not understand the difference between ordinary income tax rates and capital gains tax rates until YEARS after I had started investing. It didn’t seem relevant to be, and to be fair: it wasn’t that relevant to me until I started selling assets (to trade up, or reallocate). But, there were two major implications to my lack of knowledge in this fairly simple tax concept:
Receiving tax advice and hearing about different tax treatment of various investments had me completely lost, and wanting to stick my head in the sand.
I was missing out on the opportunity to be strategic with my investing plan in a way that would have saved me thousands on taxes.
Ordinary Income vs. Capital Gains
In the United States, taxes are divided into two main categories: ordinary income tax and capital gains tax.
Ordinary Income Tax
Ordinary income tax applies to money earned from working, like salaries, wages, or bonuses. The government uses a system of tax brackets to determine how much you owe. Essentially, the system splits people into different income groups and applies varying tax rates to each group. For example, someone earning $50,000 might pay a lower percentage on the first part of their income and a higher percentage on the rest. This progressive tax system means that as you earn more, you pay a higher percentage of your income in taxes. Ordinary income tax brackets in the US, as of 2024, are as follows:
Capital Gains Tax
On the other hand, capital gains tax applies to profits made from selling investments like stocks, bonds, or real estate. There are two main types of capital gains: short-term and long-term. Short-term capital gains come from assets held for one year or less and are taxed at the same rate as ordinary income. However, long-term capital gains, which are from assets held for more than one year, have special tax rates that are often lower than ordinary income tax rates.
The distinction in Ordinary Income Tax Brackets and Capital Gains Tax Brackets encourages long-term investment by providing incentives for investors to hold onto their assets for extended periods. Capital Gains Tax Rates for 2024 are as follows:
Some dividends, which are considered Qualified Dividends, are taxed at Capital Gains tax rates. Dividends must meet this criteria to be considered Qualified:
The dividend must be paid by a U.S. company or a qualifying foreign company.
If you purchase stock on or before the ex-dividend date and then hold it for at least 61 days before the next dividend is paid, then the dividend is a qualified dividend.
The stock must meet the holding period. For dividends to be taxed at the capital gains rate, the holding period may be 60 days for mutual funds and common stock and 90 days for preferred stock. If you don’t meet the holding period, the dividend will not be qualified.
The dividends are not listed with the Internal Revenue Service (IRS) as those that don’t qualify for preferential status.
Dividends must not be capital gains distributions or payments from tax-exempt organizations.
Overall, while ordinary income tax applies to money earned through work and follows a progressive tax system with multiple brackets, capital gains tax applies to profits from investments and is divided into short-term and long-term categories with potentially lower tax rates. Both systems play crucial roles in the taxation of income and investments in the United States, impacting individuals' financial decisions and the broader economy.
Take a look at this summary to see how investments are taxed differently:
Understanding how tax brackets were applied to ordinary income vs. long-term capital gains shifted the way I looked at taxes entirely, and it made a lot of other tax concepts become more clear to me. This is the magic of financial literacy; taking the tiniest steps to grasp concepts that may feel embarrassingly basic allow us to feel a big shift over time. This shift creates more confidence, mental clarity, and motivation to learn more.
We encourage you to start small and spend a minute each day trying to learn more about the financial literacy concept that you find to be the biggest barrier in your learning. Share that barrier with us! Drop us a DM on social media- we'd love to hear from you!
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