Capital Gains Tax vs Ordinary Income Tax

By Aiden Cox

When it comes to investing, not all income is created equal. At least not in the eyes of the IRS. As a financial planner, one of the key discussions I have with clients revolves around the difference between capital gains and ordinary income (short-term gains), and how understanding this distinction can lead to more tax-efficient investment strategies. I hear it often when people say that they are just going to live off the dividends of their investments in their retirement. Apart from the dividends never being guaranteed, there are other strategies to consider from a tax standpoint.

Today, we’ll break down the two income types, how they’re taxed, and why innovative strategies may help investors minimize tax drag and enhance after-tax returns.

What’s the Difference Between Capital Gains Tax and Ordinary Income Tax?

Ordinary Income Tax:

Ordinary income includes wages, salary, bonuses, interest income, rental income, and short-term capital gains (on assets held less than one year). This income is taxed at your regular federal income tax rate, which in 2025 ranges from 10% to 37% depending on your tax bracket.

Capital Gains Tax:

Capital gains are the profits you realize when you sell an asset for more than you paid for it.

• Short-Term Capital Gains: Taxed as ordinary income (assets held for less than 12 months).
• Long-Term Capital Gains: Taxed at preferential rates—0%, 15%, or 20%—depending on your income level.
  • Long-term capital gains are taxed at a lower rate than ordinary income, making them more attractive for tax-conscious investors.

Why This Matters for Your Portfolio

Many investors unintentionally increase their tax liability by generating too much ordinary income, especially in taxable accounts. Taxable or non-qualified accounts are non-retirement accounts that are susceptible to capital gains tax.

Dividends and capital gains tax can come from:

• High-turnover mutual funds
• Actively managed strategies that realize frequent gains
• High-yield income funds in non-qualified accounts

To reduce this tax burden, it’s crucial to structure your portfolio with tax efficiency in mind, which brings us to ETFs.

ETFs and Tax Efficiency: What Makes Them Different?

Exchange-Traded Funds (ETFs) are known for their tax advantages compared to traditional mutual funds. But why?

Some fund families have pioneered systematic investing with tax sensitivity, particularly in their ETF offerings. According to Dimensional Fund Advisors, low tax drag is one of the most under-appreciated drivers of long-term wealth accumulation.

How ETFs Minimize Taxes:

1. In-Kind Redemptions:
   ETFs often use a structure that allows them to swap securities in-kind when shareholders sell to avoid triggering capital gains.
2. Low Turnover:
   Many ETFs, especially those following an index or rules-based approach, have low portfolio turnover, meaning fewer taxable events.
3. Tax-Loss Harvesting:
   Tax management strategies to realize losses that offset gains, further reducing tax liability with the use of mutual funds and ETFs, without missing time in the market if you’re using the same approach with individual stocks, and avoiding the 30-day wash sale.

There are plenty of fund families that have ETFs and mutual funds that report consistently low or zero capital gains distributions in recent years, helping investors retain more of their returns. ¹

Real-World Impact: Tax Drag Can Cost You

Hypothetical Example:
Let’s say you invest $100,000 in a high-turnover mutual fund that generates 1.5% in annual tax drag. Over 20 years, that seemingly small percentage could reduce your ending portfolio by tens of thousands of dollars compared to a tax-efficient ETF with little to no tax drag.

*Note: This is for illustration purposes only

Final Thoughts

A tax-smart portfolio isn’t just smart, it’s necessary. As a financial planner, I always stress that after-tax returns matter more than pre-tax returns. Understanding the difference between capital gains and ordinary income and using tools like ETFs, SMAs, and exchange funds to manage tax drag can significantly impact your wealth over time. Although the taxable account is just one place to store your hard-earned dollars, there are potential benefits to both tax-deferred and after-tax accounts, such as Roth IRAs and 401(k)s, so it’s important to consider all of your options.

Want to help make your portfolio more tax-efficient?

Connect with a Canter Wealth advisor to build a customized strategy that aims to help you minimize tax drag, maximize after-tax returns, and keep more of what you earn working for your future.

Sources:

1. Avantis Investors. (n.d.). Distributions. Retrieved from https://www.avantisinvestors.com/avantis-investments/distributions/

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