Stock Market Taxes - What You Need To Know
There are pros / cons to both trading and investing, but let’s talk about one thing that is pretty set in stone stock market taxes!
When it comes to investing in the stock market, everyone has a different strategy. You have traders, who prefer to catch the “meat of a move” whether it be up or down to grow their accounts quickly. Then you have your investors, these are people who have the patience to withstand the swings in the market and keep their shares for the long haul.
Both can make you a ton of money in the long run, because the stock market is full of endless opportunities.
But which one is better?
When it comes to the stock market, I like to believe that whatever works for you and makes you money is the best strategy for you. There are pros and cons to both trading and investing, but let’s talk about one thing that is pretty set in stone when it comes to your portfolio income: taxes.
Regardless of if you are making $100 or $10,000 on a stock, chances are you’re going to be paying taxes on those gains (unless you open up an IRA). But the amount of taxes you pay differs between traders and investors.
Stock Market Capital Gains Tax
For tax purposes, the income you earn from selling your stocks are called Capital Gains.
These gains are broken down further into Short-Term and Long-Term.
Short-Term Capital Gains are realized gains from any trades that you sell before one year of holding that specific stock.
On the other hand, Long-Term Capital Gains are realized gains from shares that you hold for longer than one year.
Keep in mind that you pay taxes on realized gains, you do not pay taxes on unrealized gains.
Traders generally hold shares for shorter than one year, because they are looking to maximize their money in the short term to grow their account faster than the market average. Investors are typically holding shares for at least a year, capturing the overall move in the market.
Stock Market Tax Differences
Being a short-term trader may seem like the preferred option. The S&P 500 has moved on average 8% per year over the last 100 years. If you can beat that consistently, then short term trading seems great!
The issue with short-term trading is you pay a significantly higher tax on your gains.
Short-term capital gains are taxed at ordinary income tax rates. Meaning it will be taxed the same as your W-2 income. When you hold your shares longer than one year, you get taxed at lower rates, saving you a ton of money in the long run.
The tax code incentivizes people to hold shares long term. They want money in the stock market for as long as possible so companies can use that capital to grow their business, which will then improve the economy and the overall market. When you buy in and out of a company’s stock quickly, you will pay increased taxes on that income.
Stock Market Tax Rates
Capital gains tax increases on a sliding scale. Meaning the more money you make, the more taxes you pay. See the two charts below. The first column shows how your capital gains are taxed based on short-term vs. long-term holds. The second and third columns show your income and tax filing status.
The difference in taxes on your gains significantly increases if you sell your shares in less than one year.
For example, consider you buy 20 shares of ABC company at $50 each for a total cost basis of $1,000 and you end up selling your shares for $80 each for a total of $1,600, resulting in a $600 gain. Your annual income is $150,000.
The total tax you will pay on those gains at the end of the year depending on your holding period:
Short-Term - $144 (24% tax rate) (net gain $456)
Long-Term - $90 (15% tax rate) (net gain $510)
When you sell your shares before one year, you pay an additional $54 of tax on those gains. That’s almost 10% of your gain!
Is It All That Bad?
Like I said earlier, whatever strategy works for you is what you should do. But it is important to understand that you are paying additional taxes when you take short-term capital gains.
Sometimes you may want to sell out of a stock before a year as there are an incredible amount of factors that go into buying and selling a specific stock.
Overall, I do recommend that even if you are a short-term trader, you set money aside each month into a long-term portfolio. Investing in the market long-term will yield incredible results, and they are even greater when you start early.
Paying taxes is part of life and it’s something that you aren’t *legally* going to get around (don’t commit fraud, folks). At the end of the day, if you are paying more taxes, it means you are making more money, which is a great thing. But there are ways to limit the amount of taxes you pay and one great way to do it is by holding your shares long-term.
Bio: Carl is a Certified Public Accountant licensed in Massachusetts. Outside of his work as a CPA, he runs his own personal finance blog at https://notyourfinanceguru.com/to help teach people how to increase their income while offering strategies to save and invest their money.