Taxes have many complexities that can sometimes sneak up on people. You might end up owing taxes or owing more than anticipated. It happens quite often. Some investors and traders are not very familiar with capital gains and tax brackets. Many of them end up paying much more than they anticipated on their capital gains.
They end up being very confused or surprised when they see how much they owe in taxes on their capital gains.
By knowing what to expect when it comes to taxes you will be better equipped for the next tax season. You will choose the right type of investments or invest in the right way to owe as little taxes as possible, maybe even no taxes at all.
Any investment outside of a tax-sheltered account is subject to taxation. Robinhood is a perfect example of an account in which your investments are subject to taxation because it is not a tax-sheltered account. If you’re considering selling current investments/capital assets, tax consideration should play a role in your decision.
Each year, you will be receiving a 1099 form from your broker (like Robinhood) with information on activities within your account for the given tax year. This form is used during tax season to evaluate the taxes you owe on capital gains made throughout the year.
What does all this mean?
When you sell a capital asset (ie: stocks or bonds) at a price higher than what you originally bought it for it is referred to as a capital gain. A capital loss is when you sell a capital asset at a lower price than what you bought it for.
This is what it looks like:
Selling price – Buying price = Capital gain/loss
Capital gains and losses can happen regardless of when you sell your asset(s). If you don’t sell your assets, it is considered an unrealized gain or loss. When you sell them, it is considered a realized gain or loss. The length of time it takes you to sell a capital asset determines whether the gain or loss is long-term or short-term.
Short-term capital gain/loss is what happens when you sell an investment before 12 months of owning the asset(s).
These are taxed differently. Short-term capital gains are taxed at what’s called your marginal tax rate (discussed in the next section) per your tax bracket. Meanwhile, long-term capital gains are taxed at either a 0%, 15%, or 20% rate, this tax rate will depend on your specific tax bracket.
Short-term capital losses can be written off in taxes or offset some of your short-term capital gains. Thus, you would owe less in taxes by doing this with short-term trades. Writing off a loss simply means that you get to show less taxable income for the current tax year, this would then result in owing fewer taxes.
Tax Brackets and Marginal Tax Rates
You may not know this but the federal government charges you different tax rates for different parts of your annual income. The first dollars you earn in a given tax year are taxed less than the last dollars of your annual earnings.
Here’s an example, if you are filing as single and your annual taxable income is $50,000 for the year 2020, you will pay federal taxes at the rate of 10% on the first $9,875, 12% tax rate on the next $9,876 to $40,125, and 22% on $40,125 up to $50,000.
Your marginal tax rate is the rate at which you are getting taxed on the last dollars of your annual income. In this case, your marginal tax rate is 22%. This means that you would be paying 22% federal taxes on your last dollars of annual income.
State taxes are separate from federal taxes, they are individual by each state. These are applied to your income as well.
Here is a table that shows the tax brackets for the year 2020. You can see how the person in the example above paid taxes on each bracket. The last bracket was 22% so this is their marginal tax rate.
How Short-Term Capital Gains and Tax Brackets Connect
When you make short-term capital gains from trading or simply selling an investment before the 12 month period of owning it, the taxes you owe on that gain are equal to your marginal tax rate.
This means that for the same person in the example above making $50,000 annual income, they will be getting taxed at a rate of 22% for their capital gains. If those capital gains were to somehow move the person to the next tax bracket then they would be getting an entirely new marginal tax rate.
This person would be getting taxed at a 24% tax rate on any income made after $85,526 up to $163,300. However, if you’re making over $30k capital gains on a $50k annual income in less than a year. Please tell me your secrets because being that precise in the markets is nearly impossible, even for the most dedicated professionals.
People who claim to make that much in such a short amount of time are more than likely lying to you.
What about Long-Term Capital Gains?
Long-term capital gains (investments held longer than 12 months) are much simpler in terms of taxes and overall management. As stated before, these gains are capped at a 20% tax rate. A rate that applies only for those in the highest federal income bracket of $441,450 and over.
Remember that with long-term capital gains you only get 3 different tax rates. 0%, 15%, or 20%. The majority of people are in the 15% bracket. These people are the ones making $40,001 to $441,450 per year. Anyone making below $40,001 has a 0% tax rate on their long-term capital gains.
This is one of the many reasons why I prefer to invest for the long term. I don’t like to trade, and no matter how much people claim to beat the market, no one will ever be able to consistently beat the market. History has taught us this many times. Long term investments are the way to go. Trading is speculation, not investing. It should only be done with money you are willing to lose.
Beyond this, however, taxes are a lot crueler to short-term traders than they are to long-term investors.
Strategies to reduce taxes paid on investments exposed to taxation
First, let’s take a look at what is taxed:
- Any interest earned from corporate bonds and banks is generally taxable
- U.S. Treasury Bonds pay interest that’s state-tax-free but taxable by the federal government
- Municipal Bonds, which are issued by state and local governments, pay interest that is federal-tax-free and sometimes state-tax-free but only to residents in the state where the bonds are issued.
- Any capital gains outside of a retirement account are taxable unless it is a long-term capital gain from someone making $40,001 or less per year.
Now, what strategies can be used to avoid taxes and pay as little taxes as possible?
- Opt for tax-free money markets and bonds. These may yield less than comparable investments producing taxable earnings. However, due to their tax differences, tax-free investments could produce more earnings than their taxable opponent. This is usually the case for people in very high tax brackets. To compare which might be more profitable, subtract federal and state taxes from taxable investments to see which one nets more.
- Invest in tax-friendly stock funds. Mutual funds and exchange-traded-funds (ETFs) are funds that tend to trade less frequently and usually produce lower capital gains distributions; these are usually equal to the specific index they are following. Due to the low trading volume of these investments, the taxes owed for them are much less than anything trading at a high volume, which increases an investor’s rate of return.
- Invest for the long-term. I know this sounds like the most boring way of investing but believe me and any professional when you are told that this is the best way of investing. Trading for quick profits not only means higher taxes on your gains, but it also means that you will be losing money with capital losses. No one can consistently beat the market. Trading is not investing, trading is speculation. As said before, you only want to trade with money that you are willing to lose.
Summing it up
The amount at which you get taxed on your short-term capital gains solely depends on your marginal tax rate. The marginal tax rate is the amount that you get taxed on your last dollars of income made for a given year. This is the last tax bracket that your last dollars are getting taxed at. Your short-term capital gains tax rate is the same as your marginal tax rate.
The amount at which you get taxed on long-term capital gains caps at 20%. Only people making $441,450 or more get taxed at 20% for their long-term gains. Anyone making $40,001 to $441,450 will be getting taxed at 15% on their long term gains. For anyone making $40,001 or less, their long-term capital gains tax rate is 0%. Remember that these specific dollar amounts are subject to change every year. The tax rates have remained consistent.
Overall, I personally invest for the long-term. I don’t speculate with my money unless I’m okay with losing. I have traded a couple of times before and have had profits with those trades. But I don’t plan on doing this consistently. I always recommend long-term investments for anyone, especially beginners. If you trade with money that you cannot afford to lose, you will end in tears.
Feel more than free to leave a comment down below! I’ll be happy to respond to each of you.