Capital gains vs ordinary income
Lesson 1 · about 9 min
Education, not tax advice: rules, rates and thresholds change every year, so confirm anything you plan to act on with a qualified tax professional.
Most traders meet the tax system for the first time in April, holding a broker statement they do not understand and a bill they did not plan for. This course exists so that never happens to you. It starts with the single distinction everything else hangs on: the difference between ordinary income and capital gains.
Two buckets
The US tax code sorts your income into two broad buckets and taxes them differently.
Ordinary income is wages, salary, interest, most business income, short-term trading gains and a few other things. It is taxed on a progressive bracket schedule: the first slice at a low rate, the next slice higher, and so on. Under current law the top federal bracket is in the high thirties.
Capital gains arise when you sell a capital asset (a stock, an option, a coin, a house) for more than you paid. If you held the asset for more than one year, the gain is long-term and gets its own, lower schedule, currently 0%, 15% or 20% depending on total income. If you held it for one year or less, the gain is short-term and is simply added to the ordinary income bucket.
That last sentence is the one most active traders miss. A day trade, a swing trade, a two-week options position: all short-term, all taxed as ordinary income. The "capital gains rate" people talk about at dinner parties is the long-term rate, and an active trader rarely sees it on stocks.
An illustrative example
Assume a single filer with $60,000 of salary and $20,000 of net trading gains, all short-term. To keep the arithmetic readable, we use an illustrative marginal rate of 22% for the ordinary bucket and 15% for long-term gains. These are stand-ins, not the current tables; brackets are indexed to inflation and change every year.
| Scenario | Taxable gain | Rate applied | Federal tax on the gain |
|---|---|---|---|
| $20,000 short-term (held under a year) | $20,000 | 22% ordinary | $4,400 |
| $20,000 long-term (held over a year) | $20,000 | 15% long-term | $3,000 |
Same profit, $1,400 difference, and the only variable was the holding period. At higher incomes the gap widens because the ordinary brackets climb faster than the long-term ones.
Two extras sit on top of both buckets and are worth knowing by name:
- Net Investment Income Tax (NIIT): an additional 3.8% on investment income, including trading gains, once modified adjusted gross income exceeds a threshold ($200,000 single / $250,000 married filing jointly at the time of writing; these figures are not indexed for inflation).
- State income tax: most states tax capital gains as ordinary income at their own rates. A handful have no income tax at all. This course sticks to federal numbers; add your state's rate to every example.
Losses live in the same buckets
Capital losses offset capital gains without limit. If losses exceed gains for the year, up to $3,000 of the excess ($1,500 if married filing separately) can be deducted against ordinary income, and the remainder carries forward to future years indefinitely. That $3,000 figure has not changed since 1978, which is why a bad year can take a long time to "use up".
Example: net trading losses of $18,000 and no gains. This year, $3,000 offsets salary. $15,000 carries forward. If next year produces $10,000 of gains, the carryforward absorbs all of it, another $3,000 offsets salary, and $2,000 rolls into the year after.
Key idea: For an active trader, "capital gains" almost always means short-term capital gains, and short-term gains are taxed like a paycheck. Plan around your ordinary bracket, not the long-term rate.
Why this matters before you place a trade
Knowing your bucket changes how you read your own results. A strategy that nets 10% a year in short-term gains at a 32% combined federal-plus-state rate keeps 6.8%. The same 10% in long-term gains at 20% combined keeps 8%. Neither number is a reason to change how you trade; it is a reason to know the after-tax figure so your planning and your position sizing use real money.
Try it: Pull up last year's return (or a rough estimate of this year's income). Find your marginal federal bracket and your state rate. Add 3.8% if you are near the NIIT threshold. Write that combined number on a sticky note; it is the haircut on every short-term gain you make this year.
Recap
- Income is sorted into ordinary income and capital gains; long-term capital gains get lower rates.
- Long-term means held more than one year. Everything else is short-term and taxed as ordinary income.
- Net capital losses offset gains fully, then up to $3,000 a year against other income, and the rest carries forward.
- NIIT (3.8%) and state tax stack on top of the federal rate.
- Know your combined marginal rate so you can think in after-tax dollars.
See it drawn
Original diagrams for the ideas on this page. Illustrative, not real market data.