Welcome to the Weekly SUMmary - 03/12/2021
Many investors are being caught off guard when it comes to taxes this year.
With all of the trading happening on sites like Robinhood and other "free" brokerage platforms (read the fine print). many novice investors may be in for a shock in the coming month. There are rules when it comes to investing that professionals follow in order to minimize tax implications. Everyone knows that "The only things in life that are certain are death and taxes." - various1 In investing, we call these taxes capital gains. Capital gains tax are treated differently depending on timing and what your income level is. Today, I'm just going to reference timing.
- Short Term Capital Gains - Holding an asset for less than one year.
- Subject to Ordinary Income Tax rates.
- Long Term Capital Gains - Holding an asset for more than one year.
- Subject to tax rates based on income:
"Capital Gain Tax Rates
The tax rate on most net capital gain is no higher than 15% for most individuals. Some or all net capital gain may be taxed at 0% if your taxable income is less than $40,000.
A capital gain rate of 15% applies if your taxable income is $40,000 or more but less than $441,450 for single; $496,600 for married filing jointly or qualifying widow(er); $469,050 for head of household, or $248,300 for married filing separately.
However, a net capital gain tax rate of 20% applies to the extent that your taxable income exceeds the thresholds set for the 15% capital gain rate.
There are a few other exceptions where capital gains may be taxed at rates greater than 20%:
- The taxable part of a gain from selling section 1202 qualified small business stock is taxed at a maximum 28% rate.
- Net capital gains from selling collectibles (such as coins or art) are taxed at a maximum 28% rate.
- The portion of any unrecaptured section 1250 gain from selling section 1250 real property is taxed at a maximum 25% rate.
Note: Net short-term capital gains are subject to taxation as ordinary income at graduated tax rates."2
- Subject to tax rates based on income:
So, to make this short and sweet, if you are "day trading" or similarly, you will face significant taxes if you are having success and selling your investments sooner than holding them for one year.
Let's look at a quick example:
- Ms. Green is an average investor making a decent living at her day job and her tax rate is 25%. She has decided to trade a little more frequently. Ms. Green invests in $10,000 ABC stock and in 11 months, the stock has doubled. She has two options, sell or stay invested in the stock.
- Sell - Ms. Green sells the stock that has doubled in eleven months. Upon selling, the brokerage firm is not required to report anything to Ms. Green relating to taxes. Ms. Green goes to file her taxes a few months later and her tax professional asks for her 1099 from the broker. It appears as foreign language, and she hands it over. The tax professional congratulates her on her investment and says, "You owe an additional $2,500 in short term capital gains taxes due to the sale of your investment."
- Stay Invested - ABC stock fluctuates, but continues to stay at or above the 100% gain. Eventually, more than a year after the original investment, Ms. Green decides to sell when the stock is exactly double what she invested. She speaks to her tax professional and they say, "Congratulations, based on your income, you are in the 15% capital gains bracket and owe $1,500 in additional taxes due to the gains in your sold investments."
Obviously, it is great when investments do well and if one could get 100% returns every few months, most would be glad to pay more taxes. Unfortunately, that is not typically the situation. Clearly, in this example, Ms. Green pays less in taxes, due to the timing of her sale. If she had held the stock for one additional month, she would have saved $1,000 in taxes.
There is another topic that I will address in a future blog, Wash Sales, that can dramatically impact the tax handling of your investments.
I certainly hope that a conversation that sparked this blog was one of few such situations, but with the investing fiascos of the last couple months (see blog here), I am concerned for novice investors. I am a former public school educator that is prone to over educating at times. Please reach out if you have questions before making potentially shocking financial decisions.
This post is intended for educational purposes only and should not be considered tax advice. LPL Financial and its representatives do not offer tax advice. Investors should seek professional advice relating to any questions that may arise from this post. The hypothetical example presented is for illustration purposes only and is not intended to be representative of actual results or any specific investment. (03/21)