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From Dilip's reply

when you make a withdrawal from your Traditional IRA, no matter which of your various IRA accounts you take the money from, part of the money is deemed to be taken from the basis (and is not subject to income tax) while the rest is pure taxable income. That is, none of the rest is eligible for the reduced taxation rates for Qualified Dividends or Capital Gains and since it does not count as investment income, it is not subject to the 3.8% Net Investment Tax of Form 8960 either.

I don't quite understand it, because I don't have some basic knowledge.

How are the tax rates for different types of income taxed compared to each other?

  • wages
  • pure taxable income
  • Qualified Dividends
  • long term Capital Gains
  • short term capital gains
  • investment income which is subject to the 3.8% Net Investment Tax of Form 8960?

For the same reason, I asked:

  • 1
    Not many things are taxed as vigorously as wages... – quid Jan 12 '17 at 23:27
  • Underlying your various questions I perceive what may be a misconception. You seem to be thinking that income can be split into separate types, tax can be calculated on each type, and then these taxes can be added to get the total tax. That is not so. A person's overall tax bill always depends on their total income, in addition to how the income is distributed over categories (and possibly other things too). So it's often not possible to say "all my wages were taxed at X% and all my capital gains were taxed at Y%". The tax rates won't necessarily line up exactly with the income categories. – BrenBarn Jan 13 '17 at 5:17
6

Long-term capital gains, which is often the main element of investment income for investors who are not high-frequency day traders, are taxed at a single rate that is often substantially below the marginal rate they would otherwise be taxed at, particularly for wealthy individuals. There are a few rationales behind this treatment; the two most common are that the government wants to encourage long-term investments (as opposed to short-term speculation), and that capital gains are a kind of double taxation (from one point of view) as they are coming from income that has already been taxed once before (as wage or ordinary income). The latter in particular is highly controversial, but this is one of the more divisive political issues in the taxation front - one party would eliminate the tax entirely, the other would eliminate the difference.

For most individuals, the majority of their long-term capital gains are taxed at 15% up to almost half of a million dollars total AGI, which is a fairly low rate - it's equivalent to the rate a taxpayer would pay on up to $37,000 in wage income (after deductions/exemptions/etc.). You can see from this table in Wikipedia that it is much preferred to pay long-term capital gains rates when possible - at every point it's at least 10% lower than the tax rate for ordinary income.

Ordinary income includes wages and many other sources of income - basically, anything that is not long term capital gains. Wage income is taxed at this rate, and also subject to some non-income-tax taxes (FICA and Medicare in particular); other sources of ordinary income are not subject to those taxes (including IRA income). Short term capital gains are generally included in this bucket.

Qualified Dividends are treated similarly to long-term capital gains (as they are of a similar nature), and taxed accordingly.

The "Net Investment Tax" is basically applying the Medicare tax to investment income for higher-income taxpayers ($125k single, $250k joint). It's on top of capital gains rates for them. It came about through the Affordable Care Act, and is one of the first provisions likely to be repealed by the new Congress (as it can be repealed through the budgeting provision). It seems likely that 2017 taxes will not contain this provision.

  • I think you may be wrong about the LTCG tax rates for most individuals. It's actually zero until you hit the 25% bracket, which in 2016 is 37,650 for a single person. That's after the 4,000 exemption, 6,300 standard deduction, and other deductions for things like 401(k) or IRA. (At least in my understanding: I'm not a tax lawyer :-)) So you could easily make 50K - about the US median income - or more and not pay LTCG tax. – jamesqf Jan 13 '17 at 4:16
  • @jamesqf I suspect most people who pay LTCG make over $37,500 (single)... people making under 50k or so don't have much disposable income to invest. – Joe Jan 13 '17 at 4:22
  • @Joe - that disregards retirees who take much of their income from dividend investments in regular brokerage accounts. I know quite a few retirees who have a very modest income even including their social security. – Nathan L Jan 13 '17 at 16:48
  • @Joe: Why not? I've lived quite comfortably spending quite a bit less than 50K/yr most years, and have usually managed to save/invest something. In any case, I meant that's what the rate is for most people: whether they choose to take advantage of it or not is their business. – jamesqf Jan 13 '17 at 18:01
  • I think the definition of the word 'most' is being lost here. – Joe Jan 14 '17 at 14:40
1

This answer deals only with Federal Taxes in the United States.

Many individual states, counties, and cities have their own income taxes, payroll taxes, sales taxes, property taxes, etc., you will need to consult your state and local government websites for information about additional taxes that apply based on your locale.

Earned Income

Wages, Salaries, Tips, Cash bonuses and other taxable employee pay, Strike benefits, Long-term disability, Earnings from self employment

Earned income is subject to payroll taxes such as:

  • Social Security: If you are employed you pay half at 6.2% and your employer pays an additional 6.2% up to the 2017 limit of $127,200 and money you earn above that amount is exempt from this tax. If you are self employed you pay both halves for a total of 12.4%
  • Medicare: Same as Social Security except at the rate of 1.45% each for employee and employer (2.9% for self-employed individuals) and without the limit on earnings. In fact, for single individuals making over $200,000 ($250,000 for married filing jointly and $125,000 for married filing separately) there is a bonus 0.9% taxed for the magical 3.8% number that is called Net Investment Tax and has its own IRS form 8960. This additional 0.9% was introduced to help pay for the Affordable Care Act. This tax applies to all income including Long-term capital gains. It's called the Net Investment tax because the majority of the revenue comes from Long-term capital gains.

Earned income is also subject to income taxes which are progressively higher depending on the amount earned minus tax credits, exemptions, and/or deductions depending on how you file. There are 7 tax rates that get progressively larger as your income rises but only applies to the income in each bracket. 10% for the first 18,650 (2017) through 39.6% for any income above 470,700. The full list of rates is in the above linked article about payroll taxes.

Earned income is required for contributions to an IRA. You cannot contribute more to an IRA than you have earned in a given year.

Ordinary (Non-Earned) Income

Interest, Ordinary Dividends, Short-term Capital Gains, Retirement income (pensions, distributions from tax deferred accounts, social security), Unemployment benefits, Worker's Compensation, Alimony/Child support, Income earned while in prison, Non-taxable military pay, most rental income, and S-Corp passthrough income

Ordinary income is taxed the same as earned income with the exception that social security taxes do not apply. This is the "pure taxable income" referred to in the other linked question.

Qualified Dividends

Dividends paid by US Corporations and qualified foreign corporations to stock-holders (that are held for a certain period of time before the dividend is paid) are taxed at the Long-term Capital Gains rate explained below. Ordinary dividends like the interest earned in your bank account are included with ordinary income.

Long Term Capital Gains

Stocks, Bonds, Real estate, Carried interest -- Held for more than a year

Income from assets that increase in value while being held for over a year. Long term capital gains justified by the idea that they encourage people to hold stock and make long term investments rather than buying and then quickly reselling for a short-term profit.

The lower tax rates also reflect the fact that many of these assets are already taxed as they are appreciating in value. Real-estate is usually taxed through local property taxes. Equity in US corporations realized by rising stock prices and dividends that are returned to stock holders reflect earnings from a corporation that are already taxed at the 35% Corporate tax rate. Taxing Capital gains as ordinary income would be a second tax on those same profits. Another problem with Long-term capital gains tax is that a big portion of the gains for assets held for multiple decades are not real gains. Inflation increases the price of assets held for longer periods, but you are still taxed on the full gain even if it would be a loss when inflation is calculated.

Capital gains are also taxed differently depending on your income level. If you are in the 10% or 15% brackets then Long-term capital gains are assessed at 0%. If you are in the 25%, 28%, 33%, or 35% brackets, they are assessed at 15%. Only those in the 39.6% bracket pay 20%.

Short Term Capital Gains

Capital assets sold at a profit held for less than a year

Income from buying and selling any assets such as real-estate, stock, bonds, etc., that you hold for less than a year before selling. After adding up all gains and losses during the year, the net gain is taxed as ordinary income. Collectibles held for more than a year are not considered capital assets and are still taxed at ordinary income rates.

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