Understanding the difference between income tax and capital gains tax is a key part of smart financial planning. While both are ways the government collects revenue, they apply to very different types of money you receive.

Here are the questions you most likely have, and the answers that can help you understand the basics of these two tax categories.

Q: What is the income tax?

A: Think of Income Tax as the tax on the money you earn from your daily work and routine earnings.

• What it covers: Your wages, salary, tips, bonuses, and self-employment income. It also includes “unearned” but routine income like interest from your savings account or checking account, and ordinary dividends.
• How it works: The U.S. operates on a progressive tax system. This means your income is divided into brackets, and higher parts of your income are taxed at higher percentages (rates). Federal tax rates typically range from 10% to 37%.

Q: What is the capital gains tax?

A: Capital Gains Tax is the tax you pay on the profit you make when you sell an asset for more than you paid for it.

• What it covers: Assets you might sell include stocks, bonds, mutual funds, real estate (that isn’t your primary home), and even valuable items like collectibles or art.
• How it works: The tax is only applied to the gain (the selling price minus your original cost), not the total sale price.

Q: Why is the distinction between capital gains and income important?

A: The main reason the difference matters is the tax rate. The government generally rewards long-term investing with lower tax rates.

Capital Gains are split into two categories, and they are taxed very differently:

• Short-Term Capital Gains: You’ve held the asset for one year or less. These would be taxed the same as your ordinary Income Tax rate (10% to 37%)
• Long-Term Capital Gains: You’ve held the asset for more than one year, and you would be taxed at preferential rates dependent on your income (currently 0%, 15%, or 20%).

As you can see, the lower long-term rates offer a significant tax advantage for holding investments for over a year.

Q: What kind of taxes do I pay on my retirement accounts?

A: The biggest surprise for many retirees is that capital gains tax does not exist for traditional retirement accounts. You can buy and sell stocks, bonds, or mutual funds inside a traditional 401(k) or IRA as much as you want. Even if you make a $100,000 profit on a single trade, you owe $0 in capital gains tax at that moment. You will, however, owe tax at the time of withdrawal. When you take money out, the IRS doesn’t care if that money came from original contributions or investment growth. Every dollar is taxed at your ordinary income tax rate, just like a paycheck, as long as your withdrawals come when you are older than 59½.

With a Roth account, because you paid the tax on that income prior to investing, you will owe no tax on withdrawals as long as you are over age 59 ½ and have held the account for at least five years.

If you have an investment account that is not a designated retirement account, every time you sell an asset for a profit, you trigger a capital gain. If you held the asset for over a year, you get the lower long-term capital gains rate, but if you held it for less than a year, it’s taxed as ordinary income.

Q: How are dividends taxed?

A: Dividends are payments of income from companies in which you own stock. For tax purposes, there are two kinds of dividends: qualified and non-qualified. Non-qualified dividends are subject to ordinary tax rates, but qualified dividends are taxed at the same rate as long-term capital gains: 0%, 15%, or 20%, depending on your taxable income and filing status.

Usually, we think of capital gains as something that happens only when we sell a stock. However, if you’re not using a tax-advantaged retirement account, qualified dividends are taxed at those same lower rates as they are paid out, even if you don’t sell a single share.

All these tax treatment options create unique opportunities for investors to build a highly tax-efficient stream of income. Here are a couple of strategies you might consider:

• Tax-Efficient Compounding: If you reinvest your dividends in a taxable account, you are effectively paying a “discounted” tax rate on your growth each year. While a bond’s interest might be taxed at 24% or 32%, a qualified dividend on that same dollar amount might only be taxed at 15%.
• The “Income” Strategy: For many retirees, “living off dividends” may be a goal. Because these dividends are taxed at lower rates, a couple could potentially receive a significant amount of dividend income and fall into the 0% tax bracket for those specific gains, depending on their other total income. But there are many other factors of an income and investment strategy to consider before committing to this strategy.<br>

Be sure to speak with a professional to see if these strategies might work for you, as there are rules and limitations that may apply, along with unique personal circumstances that can impact whether these strategies would be advantageous to you or not.

Navigating the complexities of tax brackets and investment timing can be overwhelming, but you don’t have to do it alone. Contact our office today to schedule a consultation and learn how we can help you create a tax-efficient plan tailored to your financial goals.