In this episode of the Fundamentals of Investing series, Left Brain Director of Research Brian Dress interviews CEO and CIO Nolan Langford to clarify the U.S. tax treatment of ordinary income versus capital gains. The conversation begins by defining ordinary income, listing typical sources (wages, 1099 consulting fees, bonuses, RSU vesting, interest from CDs and money‑market accounts) and explaining that it is taxed at the taxpayer’s marginal ordinary‑income tax rate. They then review the progressive U.S. tax bracket system, emphasizing that only the income within each bracket is taxed at that rate and highlighting the importance of understanding one’s marginal rate. The dialogue shifts to capital gains, distinguishing short‑term gains (held < 12 months) which are taxed at ordinary rates, from long‑term gains (held ≥ 12 months) which enjoy preferential rates of 0 %, 15 % or 20 % depending on filing status and income level. Nolan shows the long‑term capital‑gains brackets, noting the zero‑rate threshold around $90 k for married‑joint filers. Finally, they discuss tax‑efficient asset placement: allocating growth‑oriented assets (stocks) to taxable brokerage accounts to capture lower long‑term capital‑gain rates, and placing interest‑generating assets (bonds) in tax‑deferred retirement accounts to defer ordinary‑income taxation. Throughout, they stress common misconceptions (e.g., “all income is taxed at my bracket rate”) and encourage investors to work with advisors to optimize tax efficiency.
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Hello and welcome again to Fundamentals of Investing. These videos are designed to explain important concepts you need to know as you work to grow your retirement nest egg and build your personal wealth. I'm Brian Dress, Director of Research here at Left Brain, joined as always by our CEO and Chief Investment Officer, Nolan Langford. Nolan, welcome to the program.
Hey, Brian. Glad to be here talking taxes, everybody's favorite topic.
Very much so. Nolan, we're recording this in the middle of April, so we're right in the thick of tax time. By the time everyone sees this, it will be behind us. Preparing for taxes going forward is very important and being tax efficient is crucial and is a big part of our business. So as we release this video, we know tax season's come to an end here in 2023, but we do think taxes should be really on the minds of investors who are conscientiously working to build their wealth. The tax code can be complex, so we wanted to cover a topic that comes up often in our practice, and that is the difference between ordinary income taxes and capital gains taxes. So to get started, we want to define terms for the viewers and then we'll dig a little bit deeper to the nuances around the topic and then also the implications between the differences between those types of taxes there. Nolan, first question, we're going to talk about ordinary income. Can you explain what ordinary income taxes are and what types of income would be subject to that sort of taxation?
Thank you, Brian. This is an important topic and I'm glad we're leading with it and just sort of set expectations and everybody's on the same page in the tax code. There's two different ways that we can be taxed on any gain or income received, and one of them is ordinary income, and that's taxed at one tax bracket. And then the other one is capital gain. And this is the either gain or loss we get when we participate in some business venture or business activity. And those are taxed at a different rate than ordinary income is taxed at.
Okay. So, Nolan, what are some of the types of income that would fall under ordinary income?
Yeah. So as the name would suggest, if I work, that is ordinary income. It doesn't matter if I consult. And I receive that income on a 1099, or if I work for a traditional employer and I receive that income on a W-2, that is going to be taxed. And that's just ordinary income is going to be taxed at my ordinary income tax rate according to my tax bracket and my filing status. But there's other types of income as well that fall into ordinary income rates. One of them is bonus income. If you work at your employer and you receive annual or quarterly bonus, that's taxed at ordinary income tax rates. And if you're fortunate enough to work for a publicly traded company and you get things like restricted stock units, then upon vesting, those also go into my ordinary income tax rates. And then there's other categories of things we tend not to think about that actually piles up our ordinary income number. For example, if you're at the bank and you do CDs at the bank, or if you do money market— and thank goodness money markets and CDs are starting to pay interest rate— we can do something with. Numbers are getting better than we've seen in a very long time. So that 2, 3, 4% that you may be getting on money markets or cash at the bank or CDs, that's also taxed as ordinary income. So those are the more common categories that flow in the ordinary income for tax purposes.
Thank you for that, Nolan. We're going to throw up the chart here, which is tax bracket chart, and we'll put that on the screen for viewers so you can take a look at this. And kind of see where you fall. Well, do you have any commentary on the tax brackets as they sit? You know, what should investors be keeping an eye on as they kind of look at where they fall and then kind of how it works?
Yeah, a few things to remember. So remember, the tax code is a progressive tiered tax system. People often tend to talk in terms of what tax bracket they're in, having a 24% tax bracket and a 32% tax bracket. But remember, it's progressive. So the way that it works, if you're married filing jointly, your first $22,000 in income is actually taxed at 10%. A lot of people may not be aware tax brackets start at 10% and they go up to 37% depending on your income. So that was the first thing to note. That is a progressive tax system. I would say the other thing to pay attention to is your marginal tax rate. And what I mean by that is if you're a— let's say you're single and your income is $100,000 per year, well, that means that you're in the 24% tax bracket and you're going to be in that tax bracket up to about $182,000 of taxable income. So you're in that bracket. And no matter what you do above and beyond that for the next $82,000, you're going to be still taxed at 24%. Now let's take a different couple. Let's take a married couple. The man works, the spouse works as well. Let's say that they both make $95,000 per year where they're right at the top of that 22% bracket at $190,000 in income. So if then they go out and they put, for example, $50,000 into a 5% CD, well, that extra $2,500 per year in interest income, that is taxable at ordinary tax rates. And that's going to be taxed at the next level, the 24%, or because that is their marginal rate for that next level. So really paying attention to what— where you are, how much more headroom is left in that bracket, and understanding the marginal rate, I think, is something important to pay attention to.
I agree, Nolan. I think a misconception sometimes can be, okay, I'm in the 24% bracket, so all income is taxed at 24%. And so that's what we kind of want to emphasize. It doesn't really work exactly that way. So that's the first point we wanted to make was talking through ordinary income. So the second topic is capital gains tax, capital gains income. So Nolan, explain what capital gains is and then kind of what would fall under that rubric.
Yeah. So thank you, Brian, for teeing this one up. I think most investors are going to have experience with capital gains or capital losses, particularly if you invest in an after-tax account. So investments, investments that are done in retirement accounts, whether it's a 401(k) or IRA or 403(b) or these sheltered type plans, you don't get an annual— there's nothing annually to file because all of that activity that happens in that IRA or that retirement plan wrapper all gets deferred until the end when you go start taking money out and then it's all ordinary income. However, in your brokerage account, these are after-tax accounts. If you're an investor that invests that way, you have experience with capital gain, capital loss. The most common version of that is you've invested in either a stock or mutual fund. In this case, let's take a stock. We bought a stock at $10, the stock doubled to $20, and then at some point we sold it. Well, the year that that transaction happens, that gets reported to us on the 1099. At the end of the year, we have to file it with the IRS to let them know we made $10 a share on that transaction. If the transaction we've held for 12 months or longer, then we get long-term capital gain treatment. If we've held the transaction for less than 12 months, we get short-term capital gain treatment. And there is a big difference. There's a big economic difference paying taxes at the short-term rate versus the long-term rate. That would be the first thing to note. And the most common transaction for publicly traded is going to be a stock. If I've held it for 12 months or longer and I made a gain, then it's actually taxed at just my ordinary tax rate. So again, going back to the married couple that made $190,000 that was in the 24% bracket, if I had a transaction of $10,000, it went to $20,000. That $10,000 in short-term gain just gets added to my income and it's taxed at that rate. However, if it's a transaction and if I held it for 12 months or longer, I'm subject to long-term capital gains treatment, which is a lot more favorable. If I'm married filing jointly, depending on my income, that could be taxed at 0%. It could be taxed at 15% or it could be taxed at 20%. And if it's long-term and dependent on my income bracket.
So now I'm going to put up the brackets here for capital gains, for long-term capital gains, so the investors can see this as well, kind of where the breakpoints are. But as you can see, if you have an income of less than $90,000 or so, capital gains will be taxed at zero. So that's really important to understand, especially if you're kind of in retirement a lot of headroom there before you start getting dinged on any, on any capital gains taxes. How can investors use this information? So the distinctions between capital gains and ordinary income, how can they use that to their advantage as they're looking to make their portfolio more tax efficient?
So one of the things that we always like to think about is asset placement. And a lot of this depends on your individual situation, your cash needs, if you have any upcoming big expenses, what your budgeting looks like. But in an ideal world, let's take an investor that owned— that wanted to be 50% invested in stock and 50% invested in bonds. And let's assume this investor had $1 million, half a million of which was in an IRA account. The other half was in a brokerage after-tax type of account. In an ideal world, we'd love to have a situation where we put all of the stocks in the after-tax brokerage account and all of the bonds in the retirement deferred account never works out that neatly. But when we're given examples, it can. And in that case, an investor would get capital gain treatment on their taxable account, which would be presumably at a much lower rate. And then for the interest income, which would ordinarily be taxed at ordinary rates, that income is deferred until distributions kick in. So that's another way to think about it. And the economic difference is very large depending on the size of the account.
Right. Nolan, you know, we, we're investors, we're always looking for the right investments and that's crucial. But of course, doing things in a tax-efficient manner, putting investments in the correct accounts is so important. And so if you're working with an advisor, you want to make sure that advisor is doing that. That's something that we're looking at for all our clients. So certainly something to keep in mind. No, that's a lot. Thanks for explaining that. I think it gives the viewers some sense of how complicated some of these issues are. So we know it can be difficult out on your own if you're doing your own investments. You may want to talk to somebody about how you can get the most tax efficient use of your money as far as when you— the way you allocate your investments. So we're going to be talking a lot about taxes this year. This is a big topic for a lot of the people out there. And we know we hear from clients, we hear from prospective clients. They're always talking taxes and we're going to be leaning into that this year. So look for future videos talking more about taxes. Nolan, thank you for being with us. We're going to thank the viewers. Oh, yes. Next time.
