Weekend Read: Understanding Capital Gains Tax vs. Income Tax

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With the upcoming election, capital gains tax has become a hot topic, with some presidential candidates proposing changes to the tax structure. These discussions have sparked questions from clients about how these potential changes might affect their investments. I thought this would be a great time to explain the key differences between capital gains tax and income tax, and how understanding them can help you make more informed financial decisions.

What Is Income Tax?

Income tax is the tax you pay on your earnings, including wages, salaries, bonuses, and self-employment income. The U.S. uses a progressive tax system, meaning your income is taxed in layers or brackets, with each layer being taxed at a different rate. For 2024, there are seven federal tax brackets, ranging from 10% to 37%.

A common misconception is that if your income places you in a higher tax bracket, all your income is taxed at that higher rate. This isn’t true. Only the portion of your income that falls into that higher bracket is taxed at that rate. Here’s an example:

Let’s say you are a married couple filing jointly and earn $250,000 in 2024. The tax brackets look like this1:

  • 10% on income up to $23,200
  • 12% on income from $23,201 to $94,300
  • 22% on income from $94,301 to $201,050
  • 24% on income from $201,050 to $383,900

In this example, your income would be taxed as follows:

  • The first $23,200 is taxed at 10%, which equals $2,320.
  • The portion from $23,201 to $94,300 (which is $71,100) is taxed at 12%, which equals $8,532.
  • The portion from $94,301 to $201,050 (which is $106,749) is taxed at 22%, which equals $23,484.78.
  • Finally, the portion from $201,051 to $250,000 (which is $48,949) is taxed at 24%, which equals $11,747.76.

So, even though you fall into the 24% tax bracket, only part of your income is taxed at that rate. The rest is taxed at lower rates. In fact, the average tax rate for the above couple is 18.43%.  This progressive system helps ensure that you’re not paying the highest rate on all your income.

What Is Capital Gains Tax?

Capital gains tax is applied to profits made from selling an asset like stocks, bonds, or real estate. There are two types: short-term and long-term capital gains.

  • Short-term capital gains apply to assets held for one year or less and are taxed at the same rate as your ordinary income (using the brackets described above).
  • Long-term capital gains apply to assets held for more than one year and are taxed at more favorable rates, typically 0%, 15%, or 20%, depending on your income level.

For example, if you sell a stock that you’ve held for over a year, the profit would be taxed at the long-term capital gains rate, which is often lower than your income tax rate. This is one reason many investors choose to hold assets for more than a year—it can result in significant tax savings2.

How Capital Gains and Income Taxes Interact

One key point to understand is how your earned income (such as wages, social security, pensions, and IRA distributions) can affect your capital gains tax rate. If your earned income pushes you into a higher tax bracket, it can also push your long-term capital gains into a higher tax bracket.

For example, if you are a single filer with $90,000 of earned income and realize $20,000 in long-term capital gains, your total income becomes $110,000. Since the capital gains are stacked on top of your earned income, part of those gains may be taxed at a higher rate. In this case, a portion of your long-term capital gains could move from the 15% tax bracket to the 20% tax bracket because your total income has exceeded the threshold.

However, it’s important to note that capital gains themselves won’t increase your income tax bracket. If you have $50,000 in long-term capital gains, that doesn’t increase your ordinary income tax rate, but it could still push your capital gains into a higher tax bracket. Essentially, capital gains are taxed separately from your regular income but can still be influenced by how much income you earn3.

Why This Matters for Your Financial Plan

Understanding how income and capital gains taxes work together can help you make smarter financial decisions and improve tax efficiency in your overall financial plan. If your income is high in a particular year, selling investments could push your capital gains into a higher tax bracket, costing you more in taxes. By contrast, if you expect a lower-income year, that might be a good time to sell investments and take advantage of the lower long-term capital gains rates.

By paying attention to the interaction between income tax and capital gains tax, you can potentially keep more of your investment gains, whether you’re saving for the future or in retirement.

As always, if you have any questions about how these taxes affect your specific situation, or if you want to explore strategies for optimizing your tax planning, feel free to reach out. I’m here to help you navigate these complexities and make informed decisions.

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Best regards,


Jeremy Raffer, MBA
Director & Wealth Manager
Author “Financial Planning for Widows”

m. 201-747-2705
w. rafferwealthmanagement.com
e. jeremy.raffer@stewardpartners.com

Steward Partners
115 W. Century Rd, Suite 145
Paramus, NJ 07652.

1https://taxfoundation.org/data/all/federal/2024-tax-brackets/

2https://www.irs.gov/taxtopics/tc409

3https://www.investopedia.com/ask/answers/052015/what-difference-between-income-tax-and-capital-gains-tax.asp

Steward Partners Investment Solutions, LLC (“Steward Partners”), its affiliates and Steward Partners Wealth Managers do not provide tax or legal advice. You should consult with your tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters.

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