# How is Ordinary Income Different From Capital Gains?

Earned income (typically from employment) is considered ordinary income. In 2009, ordinary income tax rates range from 10 to 35 percent. An individual’s marginal tax rate is the percent of the last dollar made during the year that must go towards taxes. It’s important to note that a taxpayer’s marginal tax rate is not applied to every dollar earned during the year. Examine the following chart, which illustrates the federal tax schedule for married individuals filing jointly in 2009.

As the chart indicates, all income up to \$16,700 will be taxed at 10 percent, and only income between \$16,700 and \$67,900 will be taxed at 15%. This layering of tax rates creates a distinction between a taxpayer’s marginal and effective tax rates. If a couple earned \$75,000 in a year, they would be in the 25 percent marginal tax bracket, but their actual federal tax bill would be \$11,125 (calculated by subtracting \$67,900 from \$75,000 and multiplying the result by 25 percent, then adding \$9,350). Thus, the couple’s effective federal tax rate would be 14.83 percent (\$11,125 divided by \$75,000).

Marginal rates can be used to calculate how much tax can be saved by increasing deductions. A taxpayer in the 25 percent marginal tax bracket will save 25 cents in federal tax for every dollar spent on a tax-deductible expense, such as mortgage interest or retirement plan contributions.

Capital gains tax is applied to most items purchased and sold for investment purposes. For the purposes of this writing, the items most applicable to capital gains taxes are stocks, bonds, money market accounts, and property. When a capital asset is sold, the difference between the selling price and the basis (usually what was paid for the asset plus the costs of any improvements made) is subject to capital gains tax.

Capital gains or losses are further classified as short-term and long-term. An asset that was owned for 12 months or less is considered to be a short-term asset, and any gains from the sale of short-term assets are taxed at ordinary income rates. Long-term assets are owned for more than 12 months, and qualify for taxation at favorable capital gains tax rates.

Capital gains tax rates are lower than ordinary income rates in order to give investors an incentive to invest in the economy. In 2009, taxpayers in the 10 or 15 percent marginal tax brackets qualify for the generous capital gains tax rate of 0 percent, while taxpayers who are in the 25 percent or higher marginal tax brackets pay a capital gains tax of 15 percent.

### About the author

Lon Jefferies, CFP®, MBA

Lon Jefferies is an investment advisor representative with Net Worth Advisory Group, a fee-only financial planning firm in Salt Lake City, Utah. He is a Certified Financial Planner (CFP®) and a member of the National Association of Personal Financial Advisors (NAPFA). He possesses an MBA and bachelor's degrees in Finance and Marketing from the University of Utah. Lon writes articles for local magazines such as Utah CEO, Business Connect and Utah Business Magazine, and he consistently contributes articles to online magazines such as FIGuide.com and FILife.com (by The Wall Street Journal). Additionally, Lon is an expert author at EzineArticles.com. Lon has been quoted nationally in publications such as the NY Times and Investment News.

Lon can be contacted at (801) 566-0740 or lon@networthadvice.com. Learn more about Net Worth Advisory Group at http://networthadvice.com and visit Lon's blog at http://www.utahfinancialadvisor.blogspot.com.

### One Comment

• Lori says:

I have a rental property. I’m going to retire at the beginning of 2012. Is it best to sell this property after I retire with the idea my income will be lower? Also, my financian advisor told me it would benefit me more to sell this property than to take some money from my accounts that he manages to pay off a couple of bills that I don’t want to take into retirement.

What do you suggest? My net income in 2010 was 83K.

Lori