Tax Planning Basics: Income and Capital Gains Taxes Explained

Income Tax

Income tax applies to individuals’ and businesses’ earnings, including salaries, wages, tips, bonuses, earned interest, dividends, and business profits. Income can be taxed at the federal and state levels, and state-specific income tax rates vary. This article will focus on federal income tax rates.

Income Tax is Progressive

The United States has a progressive tax system, meaning that each person’s income tax is based on the amount they earn in a given year, with higher earners generally paying more in income tax than lower earners. In 2024, income tax rates fall into brackets ranging from 10% to 37% after deductions. Earnings up to $11,600 are taxed at 10%, and earnings over $609,350 are taxed at 37%, with several other brackets in between. 

Income Tax is Marginal

To avoid discouraging people from increasing their income, the income tax system is marginal, which means different tax rates apply to different portions of one person’s earnings. When a person’s income increases beyond the threshold of the tax bracket they were previously in, only the amount of income over that threshold is taxed at the next higher rate. Income below the threshold will still be taxed at the previous rate.  For example, if a person who earned $100,000 in 2023 was given a 10% raise, they would earn $110,000 in 2024. This pay increase would bump them from the 22% tax bracket, which has an upper threshold of $100,525, to the 24% tax bracket. However, only the $9,475 of their income above the previous threshold would be taxed at the 24% rate. The rest of their income would be taxed at 22%, 12%, and 10%, based on the threshold of each bracket. 

Because the tax system is marginal, a person’s effective tax rate (i.e., the average percentage of taxable income they owe in taxes) is often much lower than their marginal tax rate, which indicates the highest percentage at which a portion of their income will be taxed. A single person whose taxable income is $100,000 after all deductions would be in the 22% tax bracket, but they would owe effective income taxes at 14.26%. A single person with a taxable income of $200,000 after deductions would be in the 32% tax bracket but would only pay a marginal rate of 19.20%. 

Income Tax Provides Opportunities for Tax Deductions and Credits 

People can decrease their income tax burden by taking advantage of tax deductions and credits. The federal government incentivizes certain behaviors such as owning a home, making charitable donations, saving for retirement, and having children by offering deductions that lower a person’s taxable income and credits that directly reduce a person’s tax obligation. Knowing which deductions and credits apply to your situation and filing your tax returns accurately can make an enormous difference in how much you owe each year. 

Capital Gains Tax

Capital gains tax applies to profits from the sale of assets or investments such as stocks, bonds, or real estate. Those profits are calculated by subtracting the asset’s cost basis from its sale price. The cost basis can be determined by adding the original price of the asset to any qualifying additions such as commissions or fees associated with the purchase of a stock or funds spent renovating an investment property to increase its value. The rate at which capital gains are taxed depends on how long the asset was owned before it was sold, incentivizing investors to buy and hold assets for longer than a year before selling them.

Short-Term Capital Gains

Assets sold for profit after having been owned for less than a year are considered short-term capital gains. Short-term capital gains are taxed at the same rate as the seller’s ordinary income tax. Short-term gains count as income, so it is possible that they may bump you into the next higher marginal tax bracket. 

Long-Term Capital Gains

Assets sold after being owned for more than a year are taxed at a lower, long-term capital gains tax rate. In 2024, long-term capital gains tax rates are 0% for individuals whose taxable income is $47,025, 15% for those with an income between $47,025 and $518,900, and 20% for those with an income greater than $518,900. Although your income affects your capital gains tax rate, long-term capital gains do not count as income and therefore cannot affect your ordinary income tax rate.