Which type of income typically has a lower tax rate than Ordinary Income?

Capital gains typically have a lower tax rate than ordinary income because they are subject to different tax treatment under the Internal Revenue Code. While ordinary income, which includes wages, salaries, bonuses, and unemployment compensation, is taxed at progressive rates that can be quite high, capital gains are generally taxed at more favorable rates. Long-term capital gains, which result from the sale of assets held for over a year, often benefit from reduced tax rates, with the maximum rate being significantly lower than the upper tax brackets for ordinary income.

This tax structure incentivizes long-term investments by making it more beneficial for individuals to invest and hold assets over time, thus promoting economic growth. The preferential rates on capital gains encourage investors to take on more risk with their investments, as they can keep more of their earnings when those investments appreciate in value.

Understanding this difference in tax treatment is crucial for effective tax planning and investment strategies, as it allows individuals to make informed decisions about how to manage their income and investments to minimize their overall tax liability.