How to Invest and Benefit from Lower Capital Gains Tax
Why It Is Better to Invest in Stock and Assets Than to Earn Ordinary Income
Salary and wages are the largest source of income for most. We earn this income by working for an employer or being self-employed. Unfortunately, when the majority of your income comes from payroll, it also means that income is subject to a higher tax rate, as it is both taxed as ordinary income and subject to payroll taxes (Social Security and Medicare). One of the most underutilized strategies to minimize your taxes is investing in stocks, bonds, and other income-producing assets. The reason is that the capital assets are subject to a capital gains tax, rather than an ordinary income tax. It is important to note that a special capital gains tax rate only applies to long-term capital gains.
Ordinary income is subject to the highest tax rates. Not only do you pay the ordinary federal income tax for the tax bracket you fall in, but you also pay 7.65% in payroll taxes. Your employer pays another 7.65%, so if you are self-employed, your payroll tax burden is 15.3%. Assuming you are in a state that charges income tax, this would be an additional tax levied on your income.
What are capital gains?
Capital gains are the profit you realize from selling a capital asset for more than the purchase price. For most investors, capital gains are largely generated by selling stocks, so most of the examples given are generalized for stock sales, but there are many other capital assets that would be subject to capital gains tax. For example, the profit you earn from selling a home is also capital gains. It is important to note that selling your primary residence is an exception, as the income is tax-exempt on the first $250,000 of profit (for single tax filers). However, this tax rate only applies if it is a "long-term" capital gain. In contrast, if you sell an asset for less than you paid, you will realize a capital loss, which reduces your taxable income.
Fund Your Brokerage Account
After opening your brokerage account, the next step is to fund the account. This is accomplished by linking a bank account and completing an electronic funds transfer. When you link a new account, the broker will typically make two small deposits in your bank account, which you will then have to input these two deposit amounts into your brokerage account to validate the account. Since these deposits have to post to your bank account before the account validation process can be completed, you can expect to wait a few business days before funds are available to transfer.
What is the difference between long-term and short-term capital gains?
An extremely important distinction for capital gains is whether the gain is a long-term or short-term gain. Short-term capital gains are taxed as ordinary income, so you lose the majority of the tax benefits. In contrast, long-term capital gains are subject to the capital gains tax rates. As of 2025, the long-term capital gains tax brackets for single filers are as follows:
- 0%: Up to $48,350
- 15%: $48,351-$533,400
- 20%: Over $533,400
Given the high threshold for the 15% long-term capital gains tax rate, most individuals with capital gains will never pay more than 15%. This is a substantial improvement considering ordinary income for a single filer making over $48,475 is taxed at 22%, and the rates go as high as 37%. It is easy to recognize the benefits of long-term capital gains over short-term capital gains, but what is the difference? Gains will be classified as long-term or short-term based on the duration for which they are held before being sold. If the assets are sold after holding them for over a year, then they are long-term capital gains. If the assets are sold in less than one year, they are short-term capital gains.
Implications of Active Trading vs. A Buy-and-Hold Strategy
Investing in stock is often done using either an active trading strategy or a buy-and-hold strategy. Understanding how capital gains tax is calculated is an important consideration for investing because income earned through active trading is subject to short-term capital gains tax. Active trading involves an attempt to time market fluctuations to buy low and sell high in the near future. It requires diligent monitoring of the stock market, as well as an understanding of market trends and current events. This strategy involves higher risk, and investors who seek to "time" the market often end up with a lower return than those who invest in index funds, such as the Standard & Poor's 500 (S&P 500). Even if they do manage to beat the market, after taking the higher tax rate into account, the profit is reduced to a great extent.
In contrast, those who employ a buy-and-hold investing strategy are less concerned with short-term fluctuations. Instead, the focus is on buying quality stocks and maintaining ownership for the foreseeable future. While active investors' income is primarily from the sale of the stock, buy-and-hold investors benefit from dividend payments (generally paid quarterly distributions to shareholders) if they hold dividend-paying stocks within their portfolio. Additionally, their stocks can appreciate over the long term, providing greater growth potential than can be realized from most short-term fluctuations. Finally, even if it appears that the gains from a buy-and-hold strategy are less, you must consider that less of the gains will go to taxes because they are subject to the long-term capital gains tax rates.
Conclusion
Capital gains tax rates are substantially less than tax rates for ordinary income, which are subject to both federal tax and payroll tax. Only long-term capital gains benefit from the lower rate. Short-term capital gains are subject to the same rate as ordinary income. As such, utilizing a buy-and-hold strategy, rather than active trading, will allow you to benefit from the reduced tax rates. The goal should be to shift as much of your income from ordinary income to capital gains or other tax-advantaged sources. By doing so, you can maintain the same standard of living as you would with a greater ordinary income taxed at a higher rate. While it is not encouraged to attempt to reduce your income in order to fall into lower tax brackets, you should make a concerted effort to practice tax avoidance, using legal methods to lower your tax payments.
