The type of tax you pay is generally based on the income you receive:
Ordinary income: This includes most of the money you make, such as wages, commissions, interest, dividends, self-employment income, alimony, distributions from IRAs/pensions and so on.
Capital gains: These are gains from the sale of a capital asset, such as a stock or bond.
The distinction between the two types of income is important. Keep in mind that long-term capital gains (that is, assets held for over a year) are generally taxed at lower rates than ordinary income.
Tax Rates On Ordinary Income
The tax rates for ordinary income depend on two factors:
1. Filing Status, which includes the following options:
- Married Filed Jointly
- Head of Household
- Married Filed Separately
With both of these factors, you will calculate your taxes based on tax brackets. For example, this is what it is for those who are single:
|If Taxable Income Is Between||The Tax Due Is:|
|0-$9,225||10% of taxable income|
|$9,226-$37,450||$922.50 + 15% of the amount over $9,225|
|$37,451-$90,750||$5,156.25 + 25% of the amount over $37,450|
|$90,751 – $189,300||$18,481.25 + 28% of the amount over $90,750|
|$189,301-$411,500||$46,075.25 + 33% of the amount over $189,300|
|$411,501-$413,200||$119,401.25 + 35% of the amount over $411,500|
|$413,201+||$119,996.25 + 39.6% of the amount over $413,200|
So, if your income is $100,000, then your tax will be $21,071.25. That is, to calculate this, you go to the bracket for income of $90,751 to $189,300. You will add the $18,481.25 to $2,590, which is 28% multiplied by the excess of your income above $18,481.25
While you are in the 28% tax bracket, your average tax rate is actually about 18.5%. This is because parts of your income are taxed at lower brackets.
If you have compensation income, your employer will take taxes out of your paycheck. This will be for federal and state income taxes as well as for Social Security and Medicare. Often there will be a flat rate of 25%. Your employer will also report the amount of the taxes on your W-2.
OK, what if you are in a higher bracket? Well, you may owe more taxes when you file your return and will probably not get a refund. You may even have to pay interest and penalties. However, to avoid this, you can make estimated quarterly tax payments to make up for the gap.
How to Calculate a Capital Gain or Loss
A capital gain or loss is equal to the amount realized from a transaction minus the cost basis (also called the “adjusted basis”).
The amount realized is that money you receive from selling your stock. You will also need to subtract any fees, such as brokerage commissions.
Next, the cost basis is the amount of your investment in the stock. The most common is, yes, the money you pay. Yet there may be other factors. For example, if you recognized compensation income from the exercise of an option, you will add this to the cost basis.
So let’s take a look at some examples:
Example 1: You sell 1,000 shares at $15 each and the brokerage commission is $25. As a result, the amount realized is $14,975 (1,000 shares X $15 minus $25 commission). Also, the stock price was $5 per share when you made the purchase of the 1,000 shares a year ago — putting the cost basis at $5,000 ($5 X 1,000). Thus, your gain is $9,975 ($14,975 – $5,000).
Example 2: Let’s say you exercise a stock option to purchase 1,000 shares of XYZ Corp. at $2 each. At the time, the market value of the stock $5. So you will have ordinary income of $3,000. This is the amount realized of $5,000 (1,000 shares X $5) and the cost basis of $2,000 (1,000 X $2). On the $3,000 of ordinary income, you will owe taxes.
Then, a few months go by and you sell the 1,000 shares for $10 each. In this case, the amount realized will be $10,000. However, the cost basis will include the amount you paid for the shares, which is $3,000, and the ordinary income recognized, or $2,000 — for a total of $5,000. Thus, your capital gain will be $5,000 ($10,000 amount realized minus the amount paid for the shares minus the ordinary income).
It’s not uncommon for people to forget to include the ordinary income — which could be a costly mistake!
Again, if you have a capital gain, you may be eligible for preferential tax rates. This is if you meet the holding period — that is, if more than a year after you make the purchase or exercise, you sell the shares. In this case, you will have a long-term capital gain, which has rates of 0%, 15% and 20%.
However, if you do not meet the holding requirement, then you will pay the ordinary tax rates on the gain.
Then what if there is a net loss? If there is a loss, then you need to net out the long-and-short gains and losses. And if you have an excess capital loss, then you can take up to as much as $3000 per year as a deduction for your ordinary income. Anything above this can be carry forward to future tax years.
Finally, you will get a Form 1099-B for your stock transactions for the prior year. But be careful. There may be adjustments you need to make, such as for the recognition of income from an option exercise.