I was in the middle of a late-night online gaming session in January when a squad-mate randomly asked if I knew anything about stocks. I told him I knew a thing or two. He had heard a lot of fervor about a Reddit favorite and decided to put in $10,000 on a whim and take his money out once it doubled, or (fingers-crossed), tripled. The advisor in me spoke first: “make sure to watch out for those short-term gains.”
“But I can take out the $10,000 I put in tax-free,” he quipped.
Perturbed by this, I did my best to explain that outside of an IRA, anything above what you invested (i.e., cost basis) is considered a taxable gain. Second, if held less than a year, capital gains are taxed just like your ordinary income, which can be up to 37% (in 2020) depending on your tax bracket. The concept seemed to whiz over his head like the shots we were dodging in the game.
The rise in popularity of trading apps such as Robinhood coupled with meme-stocks dominating discussion boards have caused a surge of more than 10 million new retail brokerage accounts added during the pandemic. However, earning (seemingly) strong absolute returns may not be as advantageous when considering taxes on those gains. Here are a few things to consider when retail trading:
- Try to limit trading to tax-deferred accounts such as a Traditional or Roth IRA. Any money you contribute into an IRA is considered ‘tax deferred’. This means that stock trades you make in your IRA aren’t subject to gains taxes if you sell stocks and use the proceeds to purchase others with your IRA. On the flip side it prevents you from claiming losses as well. Tax-deferred accounts like a traditional or Roth IRA come with a caveat: strict distribution rules, both before and after retirement.
- To the extent possible, avoid triggering short term capital gains in taxable accounts. As mentioned above, a short-term capital gain results from the sale of an asset (e.g., meme stock) owned for one year or less. While long-term capital gains are generally taxed at a more favorable rate than salary or wages, gains that are classified as short-term do not benefit from any special tax rates and can range from 10% to 37%. There is also a 3.8% surcharge for filers with higher levels of earnings. In most states there will also be additional state taxes.
- There is no tax withholding on income from investments. With wages, usually an employer sends part of a person’s paycheck to the IRS, but this does not happen with investment earnings. Plan ahead and make sure you have money set aside for taxes on your investment earnings, otherwise prepare to pay a hefty tax bill the following year.
As always, please consult your advisor or tax preparer who would understand how your personal finances and tax situation could be impacted by these trading vehicles or investment tools. Also keep in mind that these tax provisions can change wildly every year (thanks Congress). While this article was written in early 2021, many changes may have taken place by the time you smartly stumbled across it.