Most people are very familiar with the idea of ordinary income: it is the money that an individual receives in the form of wages, tips, dividends, or interest from an interest-bearing account, such as a savings account.
Many people might not understand what is meant by “capital gains,” however. The difference between the two is more than just academic since capital gains are taxed at a much lower rate than ordinary income. Thus, a person who receives money in the form of capital gains will have to pay significantly fewer taxes on that money than someone who receives the same amount of money as ordinary income.
Simply put, capital gains are profits that an individual receives from an appreciation in the value of an investment. To state that another way, capital gains are the difference between the sale price of an investment and the original purchase price of that investment. The investment can be any kind of capital asset – usually stocks, bonds, or real estate. For example, if Alice buys 1000 shares of stock at $10 per share, then sells the stock five years later for $15 per share, she will have made a profit of $5,000. That profit is a capital gain. Conversely, if the price of Alice’s shares had declined to $5 at the time of her sale, she would have suffered a capital loss of $5,000.
The capital gain is only realized once the capital asset has been sold, so people with investments in capital assets do not have to pay taxes on assets that have gone up in value as long as they have not received any income from that asset (like a stock dividend, for example). As soon as the owner sells the asset, however, any capital gains become subject to taxation.
The current maximum tax rate for capital gains is 15 percent, while the maximum tax rate for ordinary income is 35 percent. There are two justifications that are usually given for this disparity: first, proponents of the lower capital gains rate argue that the lower rate will provide an incentive for people to invest, which will drive economic growth. Second, supporters of the low rate argue that the lower rate is necessary to reduce the effect of inflation on the investment.
To illustrate that last concept, consider that someone may hold onto a capital investment for a long period of time. During that time, inflation may decrease the real value of the investment, even though the price may rise. For example, imagine that Bill sells a capital asset for 7% more than what he paid for it. Over the entire period he had the asset, however, inflation was 5%. Thus, Bill’s real gain from the sale of the asset was only 2% of the purchase price. According to its proponents, a lower capital gains tax is necessary to offset the impact of inflation on capital assets.
There are many economists and tax experts who disagree with both of the main arguments for the lower capital gains rate, however, but the policy will most likely be in place for the foreseeable future.