Understanding the Difference Between Income Tax and Capital Gains Tax

In the realm of taxation, two terms often surface: income tax and capital gains tax. Both are crucial aspects of an individual’s tax obligations. However, these two terms refer to different types of income taxes, each with its own rules and regulations. Investors must understand these financial concepts as they may impact their situation.

Income tax: An overview

Income tax is a tax imposed by the U.S. Federal government and some state governments on income generated by individuals living within their jurisdictions. Simply put, the more income you earn, the more tax you pay. Income tax applies to wages, salaries, interest, dividends, business income, and other forms of earned income.

There are three main types of income tax: progressive, proportional, and regressive.

• Progressive income tax – This is the most common type, in which tax rates increase as income levels rise. The U.S. federal income tax system is progressive, meaning that individuals and households with higher taxable incomes pay a larger share of taxes than those with lower incomes.
• Proportional income tax – This tax is a flat tax, which imposes a fixed percentage on all income levels.
• Regressive income tax – This tax system reduces tax rates as income increases.

Capital Gains tax: An overview

Capital gains tax is a levy on profits from the sale of property or investments. It applies when an individual or business sells a capital asset for more than its purchase price. This tax applies to assets such as stocks, bonds, jewelry, real estate, or a business, encompassing anything that increases in value over time.

The distinguishing factor of capital gains tax is its dependence on how long the asset is held before selling:

• Held more than a year – If the asset is held for more than a year, any profit is considered a long-term capital gain and is usually taxed at a lower rate than ordinary income.
• Held less than a year – If assets held for less than a year are subject to short-term capital gains, they are taxed at the same rate as regular income.

Capital gains tax helps encourage long-term investing, which is viewed as beneficial to the economy. The reduction in the tax rate on long-held assets helps to incentivize individuals and businesses to invest in the long term.

There are tax-efficient strategies that may help minimize one’s income tax liability, such as taking advantage of tax credits, deductions, and other incentives, such as contributing to tax-deferred investment accounts.

In conclusion

Ultimately, the goal is to understand your tax obligations thoroughly by working with financial and tax professionals. They can help you make informed decisions that align with your goals, thus promoting responsible and effective financial management.

5102595-0126b This material is for educational purposes only and does not constitute personalized tax, legal, or investment advice. Before you make any decisions regarding your personal financial situation, you should consult a financial or tax professional to discuss your individual circumstances and objectives. All investing involves risk, including the possible loss of principal. This newsletter is designed to provide general information on the subjects covered. Pursuant to IRS Circular 230, it is not intended to provide specific legal or tax advice and cannot be used to avoid penalties or to promote, market, or recommend any tax plan or arrangement. You are encouraged to consult your personal tax advisor or attorney. The source(s) used to prepare this material is/are believed to be true, accurate and reliable, but is/are not guaranteed.