Tax Rules Stock Traders Need to Know
Federal tax laws are well over 10 million words in length.
If the average person reads 250 words per minute, it would take roughly 666 consecutive hours to complete the federal tax code in one sitting — a truly demonic length of time.
Despite their complexity, however, the IRS rules embody one core truth: all income will be taxed.
That’s as true for the 9-to-5 job as it is for trading stocks.
When you sell shares for more than you originally paid, you’ll pay taxes on the profits.
These profits are officially known as “capital gains,” which incur unique tax implications according to the length of time you held your shares. Conversely, “capital losses” occur when you sell securities for less than you originally paid.
The sum of your gains and losses will play an integral role in your annual tax filing.
Note: if you’re trading in a tax-advantaged account — like a traditional IRA, a 403(b), or a 401(k) — you will not be taxed on capital gains or dividends so long as you leave the money in the account(s). Withdrawals made before the age of 59 1/2 will be taxed at your current income level, and in most cases, will also be levied an early withdrawal penalty.
Capital Gains Taxes: Short-term vs. Long-term
Profits earned from trading are split into two categories: short-term and long-term capital gains.
Earned income on stocks owned for one year or less is considered a short-term capital gain.
These profits are taxed at your current tax bracket.
On the other hand, long-term capital gains taxes apply to returns on securities held for at least one year and a day. During the 2021 tax year, long-term capital gains are taxed at rates of 0%, 15%, or 20% (depending on your income level).
In some cases, no taxes will be owed on capital gains.
According to the IRS, for example, some or all net capital gains may be taxed at 0% if your taxable income is less than or equal to $40,400 (or $80,000 if married and filing jointly).
The 15% rate applies if your taxable income is between $40,400 and $445,850 (or between $80,800 and $501,600 if filing jointly).
If your income exceeds $445,850 (or $501,600 as a married couple), your long-term capital gains rate will be 20%.
Finally, any gains from selling collectible items will be assessed a maximum 28% tax.
Dividend Taxes
If you own dividend-paying stocks, you likely receive payments throughout the year.
Such dividends are split into two categories: “qualified” and “non-qualified” dividends.
As with long-term capital gains, the tax rates for qualified dividends are 0%, 15%, or 20%. Conversely, non-qualified dividends are taxed at your regular income level.
Don’t worry about carefully separating your qualified and non-qualified dividends on your own.
If you earned at least $10 in dividends in 2021, your broker will send you a fully itemized IRS Form 1099-DIV to help you complete your annual tax return.
Note: If you earned more than $1,500 in dividends in 2021, you may also need to fill out IRS Form 1040 (Schedule B).
Calculating Your Profits
So, how much do you have to pay in taxes?
Here’s the good news: whenever you sell stock, you’re only responsible for paying taxes on your profits — not on the full sale.
In order to determine your profits, you first need to calculate your “cost basis.”
This figure includes both the amount you paid to buy the stock and any additional fees or commissions paid to execute the trade.
For example, let’s say you bought one share of Company XYZ for $100. To complete the trade, you also paid $10 in transaction fees.
Later, when you sold the stock at $150, you paid an additional $10 in closing fees.
In this case, your cost basis would be $120 — the price of the stock ($100) plus the purchase and sale fees ($20).
To calculate your profits, you would then subtract your cost basis from your proceeds:
$150 — $120 = $30.
You would then pay the short-term capital gains tax on $30. To approximate the amount owed, simply multiply your marginal tax rate by your profits.
Offsetting Losses & Tax-Loss Harvesting
As all traders can test, some losses are inevitable.
Fortunately, any losses incurred from selling stocks can be used to offset capital gains.
For the sake of example, let’s say your shares in Company A netted $3,000 in earned income, while your shares in Company B resulted in a loss of $2,000. In this case, you would simply subtract your losses from your gains and reduce your total taxable profit to $1,000.
Offsetting can also be done strategically. In other words, you can deliberately sell shares at a loss to reduce your total capital gains.
And what happens if your total capital losses exceed your total capital gains? The IRS permits you to deduct up to $3,000 in losses against your total annual income. This is known as “tax-loss harvesting.”
In the event your net capital losses exceed $3,000, you can roll over that amount to future years until the loss is exhausted.
Note: according to the “Wash Sale Rule,” the IRS forbids consumers from repurchasing recently sold stocks (or a “substantially identical” asset) within 30 days of the initial sale. In order to deduct capital losses, you must wait 30 days before reacquiring those securities.
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This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.
