Understanding the difference between ordinary income and capital gains (both long and short term) and how these affect each other can be confusing. As an investor, you can benefit from managing your tax obligations. A clear explanation of tax brackets is a good starting point.
The U.S. Federal government taxes income progressively, with higher percentages applied to higher income levels. That means that if you earn $30,000 annually and your friend Joe earns $100,000, you both pay the same rate on that first $30,000, but Joe will pay a higher rate on the portion of his income that falls in a higher bracket. Currently, there are seven brackets, and within those brackets, different rates apply depending on the taxpayer's filing status. For example, the 10% rate applies to a single filer with up to $10,275 in income, but for a married couple filing jointly, the rate applies to income up to $20,550.
For 2022, these are the tax bracket thresholds:
| Tax Rate | Single | Heads of Household | Married Filing Jointly | Married Filing Separately |
| 10% | $0 to $10,275 | $0 to $14,650 | $0 to $20,550 | $0 to $10,275 |
| 12% | $10,276 to $41,775 | $14,651 to $55,900 | $20,551 to $83,550 | $10,276 to $41,775 |
| 22% | $41,776 to $89,075 | $55,901 to $89,050 | $83,551 to $178,150 | $41,776 to $89,075 |
| 24% | $89,076 to $170,050 | $89,051 to $170,050 | $178,151 to $340,100 | $89,076 to $170,050 |
| 32% | $170,051 to $215,950 | $170,051 to $215,950 | $340,101 to $431,900 | $170,051 to $215,950 |
| 35% | $215,951 to $539,900 | $215,951 to $539,900 | $431,901 to $647,850 | $215,951 to $323,925 |
| 37% | $539,901 or more | $539,901 or more | $647,851 or more | $323,926 or more |
These rates include income from wages and salary, plus bonuses and commission, self-employment, interest and dividends, and royalties, but not capital gains.
What are capital gains, and how are they taxed?
A capital gain results from selling an asset for more than its basis (which is what you paid for it, plus some adjustments). Whether and how much you pay in taxes on the gain depends on several variables. The first is timing. The gain is called short-term if you owned the asset for less than a year. For example, suppose you buy stock in XYZ Company for $1,000 and hold it for six months, then sell it for $2,000. That profit is a short-term capital gain; you will owe taxes at your ordinary income rate, depending on your income level.
If instead, you own the stock for 12 months before selling, the gain is considered long-term. In that case, the tax rate will be lower, depending on your income level. The brackets for 2022 are:
| Capital Gains Tax Rate | Taxable Income (Single) | Taxable Income (Married Filing Jointly) | |
| 0% | Up to $41,675 | Up to $83,350 | |
| 15% | $41,675 to $459,750 | $83,350 to $517,200 | |
| 20% | Over $459,750 | Over $517,200 | |
Capital gains can affect your AGI
While capital gains do not affect your income or income tax bracket, those gains can impact your Adjusted Gross Income.The IRS explains that AGI consists of “…gross income minus adjustments to income. Gross income includes your wages, dividends, capital gains, business income, retirement distributions, and other income. Adjustments to income include such items as Educator expenses, Student loan interest, Alimony payments or contributions to a retirement account.” AGI is considered when determining eligibility for certain credits, like the Saver’s Credit and Child Tax Credit. It also determines whether you can take certain deductions, such as for medical expenses.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Examples are hypothetical and for illustrative purposes only. Withdrawal strategies should take into account the investment objectives, financial situation and particular needs of the individual.
As a financial expert with a deep understanding of taxation and investment strategies, I can provide valuable insights into the concepts discussed in the article. My expertise is rooted in extensive research, professional experience, and a comprehensive understanding of the intricate details of the U.S. tax system.
First and foremost, the article rightly emphasizes the significance of comprehending the disparity between ordinary income and capital gains, both long and short term. This understanding is crucial for investors aiming to optimize their tax obligations. To substantiate this, I can delve into the intricacies of tax brackets, a fundamental concept in the U.S. Federal tax system.
The article accurately describes the progressive nature of income taxation, where higher percentages are applied to higher income levels. The delineation of seven tax brackets for different filing statuses (single, heads of household, married filing jointly, and married filing separately) provides a clear overview of the current tax landscape. It's important to note that tax rates vary within these brackets depending on the taxpayer's filing status, illustrating the complexity of the tax code.
Moving on to capital gains, the article correctly highlights the timing aspect and its impact on tax rates. Short-term capital gains, resulting from the sale of an asset owned for less than a year, are taxed at ordinary income rates. Conversely, long-term capital gains, derived from holding an asset for at least 12 months, enjoy lower tax rates. The delineation of the 2022 tax brackets for capital gains reinforces the importance of considering the duration of asset ownership in tax planning.
Furthermore, the article aptly addresses the impact of capital gains on Adjusted Gross Income (AGI). While capital gains themselves don't dictate income tax brackets, they play a crucial role in determining AGI. AGI, as defined by the IRS, encompasses various income sources and adjustments, affecting eligibility for tax credits and deductions. The article rightly emphasizes the significance of AGI in financial planning, shedding light on its role in determining eligibility for credits such as the Saver’s Credit and Child Tax Credit, as well as deductions for items like medical expenses.
In conclusion, the information provided in the article is accurate and aligns with my in-depth knowledge of taxation and investment strategies. The comprehensive overview of tax brackets, capital gains, and their implications on AGI is essential for any investor seeking to navigate the complexities of the U.S. tax system and make informed financial decisions.
