By Hrishikesh Menon. Edited by Arjun Chandrasekar.
Overview
A major percentage of taxpayers adhere to the standard income tax brackets and its progressive taxation process. However, that minor percent – usually the elites – mostly adhere to the capital gains tax brackets: a much less known tax policy. Today we’re going to take a deep dive and demystify capital gains taxation.
Income Tax Recap
To quickly recap income taxation, it is a progressive taxation policy that consists of 7 brackets as of the fiscal year 2022. It starts off at 10% for people earning $0-$9,950 and ends with 37% for people earning more than $523,601. These numbers are for a person whose marital status is single. There are 3 other statuses under which people can file taxes and the numbers for those brackets differ. To further understand the progressive taxing system and the different types of filings, refer to our article on income tax brackets.
What are Capital Gains?
As we saw in the previous section, income tax is based on a person’s salary. A common misconception is that everyone’s main source of taxable earnings is their salary. Although most of the taxable earnings are from salaries, some come from the sale of investments that they have made in that year. The profit that is made from these sales is called capital gains. The most common types of capital assets are stocks, bonds, real estate, cryptocurrency, jewelry, etc. There are 2 types of capital gains tax brackets: short-term capital gains and long-term capital gains. Short-term capital gains are the profit made from the sale of an asset held for a year or less and long-term is the profit made from selling the asset after holding it for more than a year.
Capital Gains Taxation
Unlike income tax, capital gains tax is not progressive and based on the person’s total taxable income (salary+capital gains). Short-term gains are taxed according to the normal income tax brackets whereas long-term gains are taxed at different rates. LTCG tax has the same statuses as income tax brackets (single, married-joint, married-separate, head of household) but only 3 brackets. We will only be going over the tax brackets for a single tax filer (If you would like to see the other statuses). Starts off with 0% on capital gains for people earning between $0 and $41,675, then 15% for people earning between $41,676 and $459,750, and finally 20% for people earning more than $459,751 (as of 2022). To demystify this process further, let’s take an example: Mark makes $200,000 a year as his salary. He had bought 1,000 shares of a company trading at $10 around 3 years ago and now he is ready to sell it at $50, putting his profit at $40,000 from that stock sale. Since he had held the shares for more than a year, it would be taxed under the LTCG brackets. His total taxable income for that year would be $240,000 (salary+capital gains) which puts him in the 15% bracket so he would pay 15% of $40,000 which is $6,000. This is assuming that Mark did not have any losing investments, if he did, he has the option to count those losses with his gains and file a net capital gain to decrease the amount he would have to pay. Additionally, if Mark sold within that same year and made a profit of $40,000, that gain would be taxed at his marginal income tax rate (in this case: 35%).
Conclusion
Capital gains are the profit made from the sale of an asset such as stocks, bonds, real estate, cryptocurrency, jewelry, etc. There are 2 types of capital gains tax: short-term capital gains (STCG) and long-term capital gains (LTCG). Short-term capital gains are the profits made from selling assets held for less than a year and long-term capital gains are the profits made from selling assets held for more than a year. Capital gains tax is not progressive and the brackets are based on the total taxable income for the filing year (capital gains+other earnings). STCG is taxed based on the top marginal income tax rate and LTCG is taxed based on their own brackets. LTCG has 3 brackets: 0% for $0 to $41,675, 15% for $41,676 to $459,750, and 20% for $459,751 and up.
