201 Ordinary Income versus Capital Gains
Ordinary Income versus Capital Gains
Capital gains—the difference between what you sell a stock for and what you paid for it—are "tax preferred," and may be taxed at lower rates than ordinary income. Ordinary income includes items such as wages and interest income.
Things To Know
- Capital gains arise when you sell a capital asset for more than its purchase price.
- Qualified dividends are eligible for a reduced tax rate.
How do you get capital gains?
Capital gains arise when you sell a capital asset, such as a stock, for more than its purchase price, or basis. Capital gains are further subdivided into short-term and long-term. If a stock is sold within one year of purchase, the gain is short term and is taxed at the higher ordinary income rate. On the other hand, if you hold the stock for more than a year before selling, the gain is long term and is taxed at the lower capital gains rate.
How do you get a capital loss?
Conversely, you realize a capital loss when you sell the asset for less than its basis. While it’s never fun to lose money, you can reduce your tax bill by using capital losses to offset capital gains. Also, to the extent that capital losses exceed capital gains, you can deduct the losses against your other income up to an annual limit of $3,000. Any additional loss above the $3,000 threshold is carried over to be used in subsequent years. (Note that due to the IRS’ wash-sale rule, you cannot claim a loss if you purchase substantially identical securities 30 days before or after the sale.)
The Jobs and Growth Tax Relief Reconciliation Act of 2003
Most taxpayers pay a 15% rate on both dividends and long-term capital gains—the same level has been in place since 2003, when the Jobs & Growth Tax Relief Reconciliation Act was passed. (Beginning in 2013, investment taxes did go up for high-income earners: Single taxpayers earning more than $400,000 and married couples filing jointly earning more than $450,000 pay a 20% tax rate on dividends and long-term capital gains.)
How it was before the change
Prior to 2003, dividends were taxed at an investor’s ordinary income tax rate. The basic idea behind the 2003 dividend tax cut was to reduce the burden of "double taxation," or taxation of the same profits at both the corporate and shareholder levels, so any dividends paid out of profits not subject to corporate taxation will not be considered "qualified dividends" eligible for the reduced tax rate. Therefore, one notable exception is dividends from real estate investment trusts, or REITs, which are typically still taxed at ordinary income rates. In addition, to qualify for the reduced dividend tax rate, you must have held a stock for at least 60 days out of the 120-day period beginning 60 days before the ex-dividend date (the date on which you must be holding a stock to receive the dividend).
