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Capital Gains vs. Income Tax — Why Investors Pay Less Than Employees

In 2011, American businessman and investor Warren Buffett wrote an op-ed for the New York Times in which he famously claimed he pays a lower tax rate than any of the other 20 people in his office — including his secretary.

He said his prior year’s federal tax bill was only 17.4% of his taxable income that year, compared to tax burdens ranging from 33% to 41% for the rest of his team.

With Buffett’s estimated net worth topping more than $80 billion, how is that possible? The answer lies in the difference between how capital gains and income from employment are taxed.

Capital Gains vs. Ordinary Income

Few people take the time to analyze their tax returns. However, if you did, you might notice that different income types get taxed at different rates.

Ordinary Income

The IRS taxes most income at the ordinary income tax rates — these are the familiar tax brackets that determine the tax rate you pay on income from wages and salaries, income from a business or rental property, most interest income, and some dividends.

For the 2020 tax year, the ordinary income tax brackets are:

RateSingleMarried Filing JointlyHead of HouseholdMarried Filing Separately
10%Up to $9,875Up to $19,750Up to $14,100Up to $9,875
12%$9,876 – $40,125$19,751 – $80,250$14,101 – $53,700$9,876 to $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%Over $518,400Over $622,050Over $518,400Over $311,025

Capital Gains

Capital gains income results from selling a “capital asset” for a price that is greater than its “basis.”

The IRS considers almost everything you own, including your home, personal effects, and investments to be capital assets.

Each capital asset has a basis. Basis is the price you paid for the asset, plus any money you put into improvements.

For example, say you own a vacation home. You paid $250,000 for the property, and after you purchased it, you spent $10,000 renovating the kitchen. Your basis in the vacation home would be $260,000. If you later sold the house for $300,000, you would have a capital gain of $40,000.

We calculate capital gains on investments like stocks and mutual funds in much the same way.

If you purchase 100 shares of Apple stock (AAPL) at $100 per share, your basis in the shares is $10,000. If you later sell the stock when the price per share is $120, your capital gain would be $2,000 — that’s the $12,000 selling price minus your $10,000 basis in the investment.

On the other hand, if you decided to sell your shares after the price falls to $80 per share, you would have a $2,000 capital loss.

Short-Term vs. Long-Term Capital Gains

Capital gains and losses are categorized as either short-term or long-term, depending on how long you owned the asset.

Generally, if you owned the asset for more than one year, it’s a long-term capital gain or loss. If you held it for one year or less, it’s a short-term gain or loss.

The IRS taxes short-term gains at the same rate as ordinary income. But long-term capital gains have their own lower tax brackets. Here they are for 2020:

RateSingleMarried Filing JointlyHead of HouseholdMarried Filing Separately
0%Up to $40,000Up to $80,000Up to $53,600Up to $40,000
15%$40,001 – $441,450$80,001 – $496,600$53,601 – $469,050$40,001 – $248,300
20%Over $441,450Over $496,600Over $469,050Over $248,300

You can use capital losses to offset capital gains.

For example, say you had that $2,000 gain on Apple stock mentioned above, but you also sold 100 shares of Facebook (FB) at a $1,000 loss. You would net the two together and pay taxes on a net capital gain of $1,000.

Capital Gains vs. Ordinary Income: An Example

Now that we’ve explained the different tax brackets that apply to ordinary income and capital gains, let’s return to the question of why an investor like Warren Buffet pays a lower tax rate than his secretary. We’ll do this with a hypothetical example.

Let’s say Iris is a single taxpayer who has $70,000 in wages from her full-time job. Iris is in the 22% tax bracket, but that doesn’t mean she pays 22% on all $70,000 of income.

Instead, the first $9,875 of her income is taxed at 10%, the next $30,250 at 12%, and the final $29,875 at 22%. That works out to a total federal income tax bill of $11,190 ($987.50 + $3,630 + $6,572.50).

Iris is in the 22% tax bracket, but her effective tax rate is 16% — she pays $11,190 out of her $70,000 income.

But wait. If you’ve ever looked at a pay stub, you know that federal income taxes aren’t the only taxes deducted from your paycheck.

In addition to Iris’ federal income tax bill, she also pays Social Security tax at a rate of 6.2% and Medicare tax of 1.45% on her earnings. That’s another $5,355 out of her pocket.

Between federal income taxes and payroll tax, Iris is giving 24% of her income to the federal government.

Now let’s compare Iris’ tax rate to Keith’s. Keith is also a single taxpayer with $70,000 of income. But thanks to Keith’s grandparents, who left him a pile of money, Keith doesn’t work.

Instead, all of his income comes from long-term capital gains. The first $40,000 of Keith’s income isn’t taxed at all, because it falls into the 0% capital gains tax bracket. He pays just 15% on the next $30,000, for a total tax bill of $4,500.

Keith’s effective tax rate is just 6%. Plus, Keith doesn’t have any Social Security or Medicare taxes deducted from his capital gains. As a result, Investor Keith pays a much lower effective tax rate than Worker Iris.

Note: Iris’ and Keith’s tax bills might actually be lower due to deductions and credits that would reduce their taxable income and offset their tax liability. To keep this illustration simple, we’ve ignored the potential impact of tax deductions and credits.

Why Capital Gains Tax Rates Are Lower

In looking at the example above or reading Buffett’s op-ed, you might wonder why there’s such a big difference in how the U.S. Tax Code treats ordinary income and capital gains. Well, it depends on who you ask.

According to the Tax Foundation, a low capital gains tax rate encourages people to save and invest in the U.S. economy, and low capital gains tax rates have historically raised more in tax revenues than higher capital gains rates.

The Tax Policy Center, on the other hand, argues that tax rates on capital gains aren’t a major factor in economic growth, and the benefits of lower capital gains rates disproportionately benefit the wealthy.

That’s why some lawmakers have proposed higher taxes on investment income over the past several years. One example, the so-called “Buffett Rule,” would apply a minimum tax rate of 30 percent on all taxpayers with income greater than $1 million, no matter where their money came from.

Although that initiative didn’t pass, the Health Care and Education Reconciliation Act of 2010 created the Net Investment Income Tax (NIIT). The NIIT applies a 3.8% surtax on investment income, including interest, dividends, capital gains, and rent and royalty income for high-income taxpayers.

For these purposes, “high income” means single taxpayers with income greater than $200,000 or married couples filing a joint tax return who make more than $250,000.

Final Word

Capital gains tax rates are a highly debated topic. Advocates for lowering capital gains tax rates argue that it would increase economic growth and promote entrepreneurship. Their opponents believe raising the tax rates on capital gains would raise additional revenues and promote a more equitable tax system.

Whatever happens to capital gains tax rates in the future, it helps to understand how our tax laws treat different types of income. You can use that knowledge in your own tax planning, or simply have a better understanding of what it means when politicians and lawmakers debate the issue.

Janet Berry-Johnson is a Certified Public Accountant. Before leaving the accounting world to focus on freelance writing, she specialized in income tax consulting and compliance for individuals and small businesses. She lives in Omaha, Nebraska with her husband and son and their rescue dog, Dexter.

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