The capital gains tax rate: How it’s different than tax on other income

Young African-American businessman using his smartphone to learn more about the capital gains tax rate on his investments.Image: Young African-American businessman using his smartphone to learn more about the capital gains tax rate on his investments.

In a Nutshell

Generally, you have to pay federal taxes on all your income. But some types of income are taxed differently than others. The capital gains tax rate is typically much lower than the rate you’ll pay on other income. Here are things to know about long-term and short-term capital gains.
Editorial Note: Intuit Credit Karma receives compensation from third-party advertisers, but that doesn’t affect our editors’ opinions. Our third-party advertisers don’t review, approve or endorse our editorial content. Information about financial products not offered on Credit Karma is collected independently. Our content is accurate to the best of our knowledge when posted.

This article was fact-checked by our editors and CPA Janet Murphy, senior product specialist with Credit Karma. It has been updated for the 2020 tax year.

Income is income — or is it?

Different kinds of income may be taxed at different rates. You’ll pay one rate on income like your salary, a different rate on self-employment income, and yet another on any profit (capital gains) you get from selling assets like a home or investments.

Generally, long-term capital gains get taxed at a lower rate than ordinary income. The capital gains rate varies depending on how long you’ve owned the asset you sold for a profit.

If you’ll realize profit from selling an asset in 2020, or will be getting investment income, the capital gains tax rate may apply to you. Here’s a look at how the rate could affect your 2020 income.

What are different types of taxable income?

If you’ve ever really analyzed your own tax return, you may have noticed that different types of income get taxed at different rates. Knowing how much tax you’ll pay on each kind of income can help you figure out the best way to minimize your tax bill.

Ordinary income

Most income is taxed at the ordinary income rate — a set of brackets covering the tax rate you’ll pay on each portion of your income. Here are the ordinary income tax brackets and rates for 2020.

Federal tax brackets and rates for 2020

Tax rate Single Married filing jointly Head of household Married filing separately
10% $0–$9,875 $0–$19,750 $0–$14,100 $0–$9,875
12% $9,876–$40,125 $19,751–$80,250 $14,101–$53,700 $9,876–$40,125
22% $40,126–$85,525 $80,251–$171,050 $53,701–$85,500 $40,126–$85,525
24% $85,526–$163,300 $171,051–$326,600 $85,501–$163,300 $85,526–$163,300
32% $163,301–$207,350 $326,601–$414,700 $163,301–$207,350 $163,301–$207,350
35% $207,351–$518,400 $414,701–$622,050 $207,351–$518,400 $207,351–$311,025
37% $518,401+ $622,051+ $518,401+ $311,026+

Ordinary income includes wages and salaries, income from a business or rental property, most interest payments and some dividends.

These tax brackets are indexed for inflation, meaning they are adjusted up or down each year in response to inflation or other factors, like wage growth. Indexing avoids the “bracket creep” that occurs when inflation drives a taxpayer’s income into a higher tax bracket, resulting in higher income taxes but no real increase in purchasing power.

Capital gains

The IRS considers almost everything you own, including real estate, personal items and investments, as capital assets. For every asset, you have an “adjusted basis,” which is basically the price you paid for the asset plus any money you put into improving the asset (as in the case of a home) minus any costs you incurred (such as depreciation of a car).

When you sell a capital asset, the difference between what you received from the sale of the asset and its adjusted basis is a capital gain or a capital loss.

Capital gains and losses are classified as either long term or short term. In most cases, if you owned the asset for more than one year before the sale, it’s a long-term capital gain or loss. If you held it for one year or less, it’s short term.

Generally, long-term capital gains are taxed at a lower rate than ordinary income. Long-term capital gains have their own tax brackets. Here they are for 2020.

Tax rate Single Head of household Married filing jointly/Surviving spouse
0% $0–$39,375 $0–$52,750 $0–$78,750
15% $39,376–$434,550 $52,751–$461,700 $78,751–$488,850
20% $434,551 and more $461,701 and more $488,851 and more

Short-term capital gains are taxed at the same rate as ordinary income.

Qualified dividends are taxed at the same rate as long-term capital gains. For qualified dividends to be eligible for the maximum rate of tax on qualified dividends, all the following requirements must be met.

  • The dividends must have been paid by a U.S. corporation or a qualified foreign corporation
  • The dividends are not the type listed under “Dividends that are not qualified dividends” in IRS Publication 550
  • You meet the holding period for stock, which means you must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date

High-income earners are also subject to the Net Investment Income Tax (or NIIT), which applies an additional 3.8% tax to investment income, including interest, dividends and long-term capital gains.

How can I minimize my capital gains tax?

Whether your capital gains are subject to ordinary tax rates or more-favorable long-term capital gains rates, it makes sense to take advantage of strategies that can help minimize the tax you’ll pay. Here are a few you might consider.

Hold investments for more than one year

Because long-term capital gains are taxed at a lower rate than short-term capital gains, try to hold off on selling until you’re past the one-year mark.

Look for ways to reduce your income

Are you planning on selling an asset that will generate a large gain this year? It might make sense to look for ways to reduce your taxable income.

The NIIT kicks in when a taxpayer’s modified adjusted gross income, or MAGI, exceeds a threshold amount of $200,000 for single filers or $250,000 for married couples filing jointly.

If you’re over that threshold, you may be able to defer some income to the following tax year, make deductible retirement plan contributions, or claim other deductions that can bring down your MAGI below those thresholds.

Harvest capital losses

If you own some investments that aren’t performing well, you might be able to sell them at a loss and use the loss to offset your capital gains.

The capital gains tax rate is applied to your net capital gain, or the amount by which your net long-term capital gain for the year exceeds your net short-term capital loss for the year.

For example, say you had a gain of $10,000 from selling Stock A. Meanwhile, you notice that Stock B is down by $5,000. By selling Stock B, you can use the loss to partially offset the gain from Stock A, meaning you’d only owe taxes on $5,000 instead of $10,000.

Bottom line

Having to pay capital gains tax isn’t necessarily a bad thing. It means you made money! Still, no one wants to pay more tax than they absolutely have to.

Avoiding a higher tax bill for your capital gains is not as complicated as you might think. The key is to understand the types of capital gains you might incur and to sell assets strategically to minimize the amount you have to pay. Knowing how to crunch the numbers to your advantage can help you hang on to more of your investment returns.

A senior product specialist with Credit Karma, Janet Murphy is a CPA with more than a decade in the tax industry. She’s worked as a tax analyst, tax product development manager and tax accountant. She has accounting degrees and certifications from Clemson University and the U.S. Career Institute. You can find her on LinkedIn.

About the author: Janet Berry-Johnson is a freelance writer with a background in accounting and insurance. She has a bachelor’s degree in accounting from Morrison University. Her writing has appeared in Capitalist Review, Chase News &a… Read more.