In the last lesson, you learned what ordinary income is.
Do you remember? It’s basically income from most sources – work, rental income, whatever. I talked about how ordinary income is like pizza and how the IRS loves to get their hands on it. Are you with me? Is it coming back now?
Okay, forget pizza for a second. Now let’s say my daughter strolls by as I’m eating a bowl of whole wheat pasta. Will she want some of mine? Yeah, sure. She’ll have some, but she doesn’t love it. There won’t be any tears or begging. She’ll eat a little and then move on. I mean, it’s whole wheat pasta. It’s okay, but it’s definitely not pizza!
And this leads us to the next type of income in the eyes of the IRS. The whole wheat pasta of income. This income is called capital gains income.
To understand what capital gains income is, you first need to know what a capital gain is. Don’t worry. You’ll pick this up quickly.
Here’s an example:
You buy a house, bond, stock, or some kind of investment for $100 and then later you sell it for $125. The difference between the two is $25. That’s called growth, appreciation, a realized gain, or a capital gain. It went up in value. See? Simple. And guess what, the IRS wants a piece of that $25 capital gain. That’s why it’s called a capital gains tax.
But we already said capital gains are the whole wheat pasta of income. These capital gains are not delicious pizza. So what does this mean for us? It means that the IRS wants a piece of that gain, but not as much as if it were pizza income – oh, sorry, I mean ordinary income. That means you pay less tax with capital gains than with ordinary income.
Which of these requires you to pay more tax:
- $25 from a job
- $25 gain on a stock you sold?
If you guessed the $25 from your job, you’re correct!
Most people have heard of Warren Buffett, but have you heard the Warren Buffett Rule?
If you’re Warren Buffett, and one of the richest people in the world, you get to make the rules. No, that’s not it. It’s this: he’s a pretty generous fella. He doesn’t think it is fair that people who work have to pay a higher tax rate than people who make the same amount of money by investing. In fact, he said that he pays a lower tax rate than his secretary. What does he mean by that? Warren makes almost all of his money from capital gains – by selling investments that have gone up in value. His secretary makes all of her income by working a job. You know the IRS takes a greater percentage of money people make through ordinary income than they take of investments going up in value, such as capital gain income. It’s crazy but true.
Want to know something else that’s true?
I make a dish with lentils, peas, corn, and beans. It’s really healthy but doesn’t have a lot of taste to it. If I’m eating my last bowl of this dish and my daughter strolls by, guess what she’ll do? She’ll keep on a strollin’! She wants nothing to do with my lentil concoction.
Now, if only there were a type of income that the IRS didn’t want a piece of.
If only there were lentil income! And, hallelujah, there is! But you have to wait for the next lesson. Sorry!
The proceeding blog post is an excerpt from Get Money Smart: Simple Lessons to Kickstart Your Financial Confidence & Grow Your Wealth, available now on Amazon.
About the Independent Financial Advisor
Robert Pagliarini, PhD, CFP®, EA has helped clients across the United States manage, grow, and preserve their wealth for the past 25 years. His goal is to provide comprehensive financial, investment, and tax advice in a way that was honest and ethical. In addition, he is a CFP® Board Ambassador, one of only 50 in the country, and a real fiduciary. In his spare time, he writes personal finance books, finance articles for Forbes and develops email and video financial courses to help educate others. With decades of experience as a financial advisor, the media often calls on him for his expertise. Contact Robert today to learn more about his financial planning services.