Is Ordinary Income Different From Capital Gains?

Earned income (typically from employment) is considered ordinary income. In 2009, ordinary income tax rates range from 10 to 35 percent. An individual's marginal tax rate is the percent of the last dollar made during the year that must go towards taxes. It's important to note that a taxpayer's marginal tax rate is not applied to every dollar earned during the year. Examine the following chart, which illustrates the federal tax schedule for married individuals filing jointly in 2009.

o 10% on the income between $0 and $16,700
o 15% on the income between $16,700 and $67,900; plus $1,670
o 25% on the income between $67,900 and $137,050; plus $9,350
o 28% on income between $137,050 and $208,850; plus $26,637.50
o 33% on income between $208,850 and $372,950; plus $46,741.50
o 35% on the income over $372,950; plus $100,894.50

As the chart indicates, all income up to $16,700 will be taxed at 10 percent, and only income between $16,700 and $67,900 will be taxed at 15%. This layering of tax rates creates a distinction between a taxpayer's marginal and effective tax rates. If a couple earned $75,000 in a year, they would be in the 25 percent marginal tax bracket, but their actual federal tax bill would be $11,125 (calculated by subtracting $67,900 from $75,000 and multiplying the result by 25 percent, then adding $9,350). Thus, the couple's effective federal tax rate would be 14.83 percent ($11,125 divided by $75,000).

Marginal rates are used to calculate how much tax can be saved by increasing deductions. A taxpayer in the 25 percent marginal tax bracket will save 25 cents in federal tax for every dollar spent on a tax-deductible expense, such as mortgage interest.

Capital gains tax is applied to most items purchased and sold for investment purposes. For the purposes of this writing, the items most applicable to capital gains taxes are stocks, bonds, money market accounts, and property. When a capital asset is sold, the difference between the selling price and the basis (usually what was paid for the asset plus the costs of any improvements made) is subject to capital gains tax.

Capital gains or losses are further classified as short-term and long-term. An asset that was owned for 12 months or less is considered to be a short-term asset, and any gains from the sale of short-term assets are taxed at ordinary income rates. Long-term assets are owned for more than 12 months, and qualify for taxation at favorable capital gains tax rates.

Capital gains tax rates are lower than ordinary income rates in order to give investors an incentive to invest in the economy. In 2009, taxpayers in the 10 or 15 percent marginal tax brackets qualify for the generous capital gains tax rate of 0 percent, while taxpayers who are in the 25 percent or higher marginal tax brackets pay a capital gains tax of 15 percent.

Your financial planning efforts should always consider tax implications. Recruit an independent fee only financial planner who prefers to work closely with your tax preparer.

Tax Saving Strategies with Stock Trading

If you trade in stocks, you need to have tax savings strategies in place, or come April 15, your profits will look a lot smaller after the IRS has taken its share.

However, the good news is that there are certain tax savings strategies with stock trading that you can implement to reduce your taxes.

Although we use investor and trader as we please, in the world of taxes these to words have different meanings and your taxes will be affected according to the meaning you put. Therefore, it is better to understand how the IRS views a trader and an investor so that you can benefit from it.

If you spend you days buying and selling stocks, then you are trader. If you are a trader, you save yourself a lot of money when it comes to paying taxes. As a trader, you can deduct all your investing expenses from your tax returns. These expenses can be newsletter subscription, home office and computer equipment.

Now how can you decide whether you are a trader or an investor? There is no guideline laid out to distinguish between a trader and an investor other than the several court cases. According to these court cases, you are a trader if you spend a lot of time trading and you do not have a regular full time job. But you can also be part time trader but you would have to buy and sell stocks on a daily basis. In addition, you are a trader if you have established a regular and continuous pattern for trades, and you ultimate aim is to profit from short-term market swings rather than keeping stocks for long-term gains.

However, you can be both a trader and investor. But you should separate your long-term investments from your short-term investments so that you are not caught by IRS for cheating.

From the IRS's perspective, a trader is self-employed and you can deduct all your expenses on Schedule C. Write offs in Schedule C reduces your adjusted gross income and you can fully deduct your personal exemptions While an investor has to account for all his expenses on Schedule A, and they can only write off the amount that exceeds 2 percent of the adjusted gross income.

In addition, as a trader you can deduct margin account interest on Schedule C and take an immediate write off of up to $128,000 for 2008 and $125,000 for 2007 for equipment you used in your trading activities for more than fifty percent of the time. Plus, you will not have to pay self-employment tax on your net profit because capital gains are exempt from it.