Ordinary Income, Capital Gains and Qualified Dividends

Before you learn about different types of investment vehicles and how to choose the investment vehicles that can best serve your need, you should be well acquainted with the following three things:

1. What are Ordinary Income and Capital Gains
2. How they are treated differently for tax purpose
3. What are Taxable and Tax Deferred Investment Accounts

Ordinary Income

Ordinary income is usually characterized as income other than (long-term) capital gain. Ordinary income can consist of income from wages, salaries, tips, commissions, bonuses, and other types of compensation from employment, interest, dividends, or net income from a sole proprietorship, partnership or LLC. It is categorized into two different categories- Earned Income and Business Income

Earned Income

Any money derived from a paid work comes under the category of earned income. If you work in a job- look at your pay stub and you will see that there are two types of taxes withheld from earned income (Social Security and Medicare) that are not taken against any other type of income. Self employed persons also pay these two taxes but it is labeled as self employment tax.

People with earned income may be eligible for Earned Income Tax Credit (EIC). IRS publication 596 explains the earned income credit and you can click here to see more details on EIC.

Business Income

Any residual profit (Gross profit - all expenses including your salary) comes under the category of business income. Business income is not subject to the self employment tax and that is where the people who own or are share holders in S corporation save taxes.

Unearned Income

Unearned income is money that you receive without doing “work” for it. Unearned income includes:

• Income from interest
• Dividends
• Capital gains
• Income from retirement account distributions
• Unemployment compensation (but you do pay taxes on unemployment benefits)
• Social Security benefits
• Debt forgiveness
• Money won from gambling
• Some real estate income
• Income from real estate
• Income from trust

Income from partnership or S corporation, without being an active part of the management (that might also be considered as capital gains)

Capital Gains

Long-term capital gains are taxed differently than short-term capital gains and earned income. This means that even if you are in a higher tax bracket, your long-term gains are often taxed at a lower rate (upto 20%). This can be very helpful to you — especially if you have a lot of investment income.


Similarly if a stock is sold within one year of purchase, the gain is short term and is taxed at the higher ordinary income rate. On the other hand, if you hold the stock for more than a year before selling, the gain is long term and is taxed at the lower capital gains rate.


Dividends

The amount of tax you'll pay on dividend income varies depending on the dividend tax rate associated with your overall income and whether or not dividends are ordinary dividends or qualified dividends.

Ordinary Dividends

Ordinary dividends are a share of a company's profits passed on to the shareholders on a periodic basis. Ordinary dividends are taxed as ordinary income and are reported on Line 9a of the Schedule B of the Form 1040. All dividends are considered ordinary unless they are specifically classified as qualified dividends.

Qualified Dividends

Qualified dividends, as defined by the United States Internal Revenue Code, are ordinary dividends that meet specific criteria to be taxed at the lower long-term capital gains tax rate rather than at higher tax rate for an individual's ordinary income.

Below is the table showing the tax rate on qualified dividends and long term capital gains:

Here are three important links I found on off-setting your capital gains in case of capital loss, including what can be off-set and what can not be off-set:

Capital Gains and Losses

Can a Short-Term Capital Loss Be a Tax Write-Off Against Ordinary Gains?

Rules for Capital Losses