In the world of money, not all income is created equal. Two people can earn the same amount, yet one ends up paying twice as much in taxes while the other quietly gets richer. The difference lies in how that money is earned through earned income or capital gains. One is taxed like labor, the other is rewarded like ownership. This is why billionaires, real estate moguls, and savvy investors often build wealth far faster than high-salaried professionals.
In this blog, we’ll break down what capital gains are, how they differ from wages, how the tax code treats them, and why the wealthiest people in the world design their entire financial life around generating more of them.
The Three Main Types of Income:
The IRS doesn’t treat all income the same, and neither should you. Broadly, there are three categories of income in the U.S. tax code: earned income, portfolio income, and passive income. Each is taxed differently, and the difference is far from small.
Earned income comes from wages, salaries, and freelance work. It’s the most heavily taxed form of income. In 2024, federal income tax rates range from 10% to 37% depending on your bracket. If you’re self-employed, you also face a flat 15.3% payroll tax for Social Security and Medicare.
Portfolio income: includes capital gains from selling assets like stocks, real estate, or crypto held for more than a year. Long-term capital gains are taxed at preferential rates 0%, 15%, or 20% depending on your income level, and completely avoid payroll taxes. Qualified dividends fall under this category too, and often get the same favorable rates.
Passive income comes from sources like rental properties or limited partnership investments. This type can benefit from depreciation and other tax shelters, making it even more tax-efficient.
The takeaway?
How you earn your money affects how much of it you keep.
A Real-Life Tax Difference Example:
Let’s imagine two people each make $200,000 in one year.
Person A is a high-paid employee, say a doctor or lawyer. That income is taxed as earned income. They’ll pay around $45,000 in federal income tax (roughly 24%–32% effective rate) and about $15,300 in payroll taxes if self-employed. In total, that’s about $60,000 in taxes, leaving them with a net income of $140,000.
Person B earns the same $200,000, but from selling shares of stock they’ve held for more than a year. Their income is taxed at the 15% long-term capital gains rate, which comes to about $30,000. They pay no payroll tax. Their net income? $170,000.
That’s a $30,000 difference for the same amount of income, purely because of how the money was earned.
How the Wealthy Structure Their Income:
This tax difference explains why wealthy people actively design their income streams to qualify as capital gains rather than earned income. Startup founders often take minimal salaries and instead hold large amounts of company equity. When that equity is eventually sold, it’s taxed at the lower capital gains rate or sometimes not at all, thanks to exemptions like the Qualified Small Business Stock (QSBS) rule, which can allow up to $10 million in tax-free gains.
Other strategies include the “buy, borrow, die” method, where investors buy appreciating assets, borrow against their value for spending money (which isn’t taxed), and then pass the assets to heirs. Upon inheritance, the assets get a step-up in basis, erasing capital gains tax.
This is the reason Warren Buffett famously revealed that he paid only a 17.4% effective tax rate on $62 million of income, while many of his employees paid between 33% and 41%. His wealth came almost entirely from capital gains and dividends, not wages.
Why Capital Gains Are Taxed Less:
The history behind this policy goes back over a century. In 1921, the U.S. government wanted to encourage investment in businesses, housing, and land. To do that, they decided that profits from selling these investments would be taxed at a lower rate than wages. The idea was simple if investors got to keep more of their profits, they’d be more willing to put money into the economy.
This approach isn’t unique to the U.S. Many countries favor capital gains over earned income:
- UK: Capital gains tax is 10–20%, often below income tax rates.
- Germany: Hold an asset for over a year, and you may pay no tax at all.
- Australia: A 50% discount on gains from assets held over 12 months.
- Singapore: No capital gains tax whatsoever.
While the original goal was to boost economic growth, it has created a significant gap between how labor and ownership are taxed, a gap that heavily benefits the wealthy.
The Power of Ownership Over Labor:
Jobs are important, but in the modern economy, owning income-generating assets provides more security and freedom than earning a paycheck alone. The share of total income going to workers has been declining for decades. In 1970, workers received about 64% of the national income in the U.S.; by 2023, it had fallen below 59%.
At the same time, asset prices have soared. Since 1990, the S&P 500 has grown by over 1,600%, while average wages have increased by only about 18% after adjusting for inflation. Those who owned stocks, real estate, or businesses saw their wealth grow exponentially compared to those relying solely on salaries.
Technology is accelerating this shift. AI and automation enable companies to expand without significantly increasing their workforce. Jobs are becoming less stable, salaries grow slowly, and skills become outdated faster than ever. In contrast, assets don’t get sick, don’t retire, and can make money while you sleep.
How to Shift Toward Capital Gains Income:
If you want long-term financial freedom, you need to gradually transition from labor-based income to growth-based income. This doesn’t mean quitting your job tomorrow, it means building assets alongside your work. Here are practical starting points:
- Invest in the stock market: Start with index funds or ETFs. Holding them for the long term qualifies you for lower tax rates.
- Buy real estate: Rental properties can generate passive income and appreciate over time.
- Build a business: Even a small online venture can grow in value and be sold later for capital gains.
- Reinvest profits: Let your assets compound without cashing out too early.
Understanding the tax implications of each income type will help you keep more of what you earn and shift your financial focus toward ownership.
Conclusion:
The difference between earned income and capital gains is one of the most important financial concepts you can learn. The tax code rewards those who let money work for them rather than those who only work for money. This is why wealthy individuals can legally pay a smaller percentage in taxes than high-income employees.
Jobs are a great starting point; they provide stability, skills, and a foundation. But if you want long-term wealth and freedom, you must start building or buying assets that generate capital gains and passive income. The earlier you make this shift, the sooner you’ll experience the benefits of lower taxes, greater financial security, and the ability to grow wealth even when you’re not working.
The future belongs to those who understand that ownership, not just effort, is the ultimate wealth-building tool.
FAQs:
1. What is the main difference between earned income and capital gains?
Earned income comes from wages, salaries, or freelance work and is taxed at higher rates, often with additional payroll taxes. Capital gains come from selling investments like stocks or real estate and are usually taxed at lower rates, with no payroll taxes.
2. Why do wealthy people prefer capital gains over earned income?
Capital gains are taxed more favorably, allowing the wealthy to keep a larger share of their earnings. They often structure their income to come from asset sales, dividends, and investments instead of salaries.
3. Can you give an example of how taxes differ between earned income and capital gains?
If two people each make $200,000—one from a salary and the other from long-term capital gains—the salary earner may pay around $60,000 in taxes, while the investor may pay only about $30,000.
4. How can an average person shift toward earning more capital gains?
Start investing in assets such as index funds, real estate, or small businesses. Hold investments for the long term to benefit from lower tax rates, and reinvest profits to grow wealth.
5. Why does the tax code favor capital gains over wages?
Historically, lower capital gains taxes were introduced to encourage investment in businesses, housing, and the economy. While it promotes growth, it also widens the wealth gap between those who earn from labor and those who earn from ownership.