Join Jim Stice for an in-depth discussion in this video Ordinary income and capital gains income, part of Finance Foundations: Income Taxes.
- Now let's talk about two different kinds of income out there. There's ordinary income and there's capital gains income. Ordinary income is just like it sounds, it's ordinary. The wages that you get from the job that you have your salary, that's ordinary income. Let's say you've got a savings account in the bank and you earn interest, that's ordinary income. Capital gains income is when you make an investment. Let's say you buy a stock portfolio, and hopefully you're going to buy it low and sell it high. Let's, for example, say I buy a stock portfolio at $1,000 and I sell it at $1,300, that $300 difference, the amount that it went up, is called capital gains income.
So there's ordinary income from wages, salary, interest, and then there's capital gains income, income from investments. Worldwide, and particularly in the United States, capital gains income is typically taxed at a lower rate. Now we could get in a long philosophical discussion about whether this is right or wrong, let me just give you the rationale on both sides. The reason that capital gains income is typically taxed at a lower rate is one, the government wants to encourage people to invest in businesses, invest in portfolios for savings purposes, so to encourage that type of investment will tax any capital gains income at a lower rate.
In addition people say, "Listen, if I'm going to invest "money in a stock portfolio, "I already paid tax on that money "when I originally made it. "You're going to tax me again when I invest it?" That's the rationale in favor of taxing capital gains at a lower rate. On the other side, income is income. If I work through the sweat of my brow and make money I should pay tax on that. If I invest my money and my investments go up in value, I should have to pay tax on that, there's no difference, it's just a different way to make income.
Capital gains income should be taxed at the same rate as anything else. Those are the arguments on both sides. The fact is that in most jurisdictions around the world, capital gains income is taxed a lower rate. In fact, in some places capital gains income is not taxed at all. In the United States ordinary income is taxed at one rate, capital gains income is taxed at a lower rate. Now, let's go back to our simple tax system. For income from zero to 50 you don't pay any tax at all, that's the first tax bracket.
For income above $50 the tax rate is this, if it's ordinary income you pay a rate of 50 percent. If it's capital gains income you pay a rate of 20 percent. We're introducing the notion of ordinary income and capital gains income, two different kinds of income with two rates, zero from zero to 50, and 50 percent above $50. Now, how much income tax would you pay if you made $100? Well it turns out depends on what type of income that is. If the $100 you make is ordinary income, meaning you just went to your job, and that's your wage, or that's your salary, or you had some interest that you made on a savings account, that $100 is ordinary income, and it's going to be taxed at zero on the first 50, and at the rate of 50 percent on the second 50, so $25 in taxes, the same thing we saw before, that's ordinary income.
If, on the other hand this $100 in income that you made is capital gains income, in other words you invested $100 in a mutual fund, and it went up to $200, it doubled in value awesome. I'd like to see that, invest $100 it doubles in value, and goes up to $200 and then you cash out. That $100 gain that you made is capital gain, and that gain is going to be taxed at the capital gains tax rate, in this case 20 percent, so the first $50 is not taxed at all, it's in the zero percent tax bracket.
The second $50 would be taxed at the capital gains rate of 20 percent, in our simple system you'd pay based on that 50, you'd pay $10, $50 times 20 percent, you'd pay $10 in tax if it was capital gains income. So if somebody gives you your choice, do you want to classify this income as ordinary income and pay $25 in tax, or capital gains income and pay $10 in tax, which would you prefer? Well, if it's legal you'd prefer to pay the $10. Here's is where a lot of the complex tax shelter arrangements arise.
You've heard of tax shelters, tax shelters take on many forms. One form is doing this, structuring your affairs so that your income can be classified as capital gains income rather than ordinary income for obvious reasons, capital gains income is taxed at lower tax rates. Lots of things both legitimate and shady have been done to create tax shelters to change the nature of income, to change it from ordinary income to capital gains income. When you hear discussions of tax shelters and this and that, this is one of the things that people are talking about, trying to change the nature of income from ordinary income to capital gains income, because capital gains income is typically taxed at a lower tax rate, but overriding everything with respect to income taxes is this, there are precise rules set down by the government where you live, and your objective in income tax accounting is following those rules so that you comply with the law.
You want to pay all the tax that you owe, it's certainly a legitimate thing to plan your affairs to pay the minimum tax allowable under the law, but you want to make sure that you obey the rules and pay the tax that you owe.
This is a self-contained introductory course to income tax, but if you'd like more information about accounting in general, check out the Stices' foundational course, Accounting Fundamentals.
NOTE: The information in this course applies only to the United States.
- The history of income tax
- Tax brackets, rates, deductions, and credits
- Completing a basic tax return (1040A)
- Tax planning
- Shifting income
- Understanding corporate income taxes
- Avoiding tax-evasion schemes
- Tax issues for small businesses