Capital Gains vs. Ordinary Income: What Investors Should Know

8 January 2026

When it comes to making money from investments, not all income is treated the same. Taxes can take a hefty bite out of your earnings, and understanding the difference between capital gains and ordinary income can help you keep more of what you make.

If you’re an investor—or thinking about becoming one—you need to know how your profits will be taxed. Otherwise, you could end up paying way more than necessary. Let’s break it down in plain English.

What Are Capital Gains?

Capital gains are the profits you make when you sell an asset for more than you paid for it. This could be stocks, real estate, cryptocurrency, or other investments.

For example, if you buy a stock for $1,000 and sell it later for $1,500, you’ve made a $500 capital gain. But before you start celebrating, remember: The IRS wants a piece of that profit.

Short-Term vs. Long-Term Capital Gains

The tax rate on your capital gains depends on how long you’ve held the asset before selling it.

- Short-term capital gains (held for one year or less) are taxed at your ordinary income tax rate.
- Long-term capital gains (held for more than a year) are taxed at a lower rate, which is usually 0%, 15%, or 20%, depending on your income bracket.

| Capital Gain Type | Holding Period | Tax Rate |
|-------------------|----------------|----------------------|
| Short-Term | 1 year or less | Same as ordinary income (10% - 37%) |
| Long-Term | More than 1 year | 0%, 15%, or 20% |

Why Does This Matter?

Holding onto an investment for over a year can save you a lot on taxes. That’s why many smart investors play the long game instead of making quick trades.

What Is Ordinary Income?

Ordinary income includes wages, salaries, bonuses, rental income, and interest from savings accounts. It’s also how your short-term capital gains are taxed.

Unlike capital gains, which have lower tax rates for long-term holdings, ordinary income is taxed at your standard tax bracket—which can go as high as 37% for high earners.

Sources of Ordinary Income

- Salary or wages from a job
- Interest income from savings accounts, bonds, or CDs
- Business income if you’re self-employed
- Dividends (Ordinary ones, not qualified dividends)
- Rental income (though there are often deductions available)

Since ordinary income is taxed at higher rates than long-term capital gains, it’s generally more expensive from a tax standpoint.

Capital Gains vs. Ordinary Income: Key Differences

| Feature | Capital Gains | Ordinary Income |
|---------------------|--------------------------------|--------------------------------|
| Source | Selling investments/assets | Salary, wages, interest, business income |
| Tax Rate | 0%, 15%, or 20% (long-term) or ordinary rate (short-term) | 10% - 37% (based on tax bracket) |
| Holding Period | Must be sold for it to be taxed | Earned regularly in varying forms |
| Tax Efficiency | More efficient (especially long-term) | Higher tax burden |

Which Is Better for Investors?

If you’re looking to grow your wealth efficiently, long-term capital gains are the way to go. You get to pay a lower tax rate compared to ordinary income, helping you keep more of your profits.

That’s why many seasoned investors hold onto their investments for more than a year before selling—to take advantage of the lower tax rates.

How to Minimize Taxes on Capital Gains

Nobody likes paying more taxes than they have to. Here are some strategies to reduce your capital gains tax bill:

1. Hold Investments for Over a Year

As mentioned earlier, holding onto your investments for more than one year lets you qualify for the lower long-term capital gains tax rates.

2. Use Tax-Advantaged Accounts

Investing through Roth IRAs, Traditional IRAs, and 401(k)s can help defer or even eliminate capital gains taxes on your investments.

3. Tax-Loss Harvesting

If you’ve made some bad investments, you can sell losing stocks to offset your capital gains. This strategy helps reduce your taxable income.

4. Gift or Inherit Assets

Giving assets to family members in lower tax brackets can help them pay less in taxes. Also, assets passed down after death often get a step-up in basis, meaning the new owner only pays taxes on gains made after inheriting the asset.

5. Smart Charitable Donations

If you donate appreciated assets (like stocks) to a qualified charity, you may be able to avoid capital gains taxes while also getting a tax deduction.

Ordinary Income Tax Strategies

While capital gains have an obvious tax advantage, there are ways to reduce ordinary income taxes too:

1. Max Out Retirement Contributions

Contributing to 401(k)s, IRAs, and HSAs reduces your taxable income, which means you pay less in taxes upfront.

2. Take Advantage of Tax Deductions

Common tax deductions include:
- Mortgage interest
- Student loan interest
- Medical expenses (if they exceed a certain threshold)
- Business expenses (if you’re self-employed)

3. Use Tax Credits

Credits like the Earned Income Tax Credit (EITC), Child Tax Credit, and American Opportunity Credit directly reduce the taxes you owe.

Final Thoughts

At the end of the day, knowing the difference between capital gains and ordinary income can be a game changer. If you’re an investor, long-term capital gains offer major tax advantages over ordinary income. By strategizing when and how you sell investments, you can keep more of your hard-earned money.

Taxes might not be the most exciting topic, but understanding them can make a huge difference in your financial future. So, whether you’re just starting out or already have a solid portfolio, play smart, plan ahead, and make tax efficiency a priority.