It’s Tax Time!
Can you guess what one of the most dreaded chores any citizen in the U.S. has to endure? You guessed it…filing tax returns. I know it’s a sucky feeling sometimes because you’re giving your hard-earned money away to Uncle Sam.
Even if your only income stream is documented solely on a W2, having to file your taxes is such a hassle. Did you know that in the UK, with some exceptions, taxes are done via a pay-as-you-earn system? Japan has a similar tax return structure where you only need to file if you meet certain conditions, like if you’re in a high-income bracket. I mean come on, America, get with the times.
Dealing with taxes becomes even more cumbersome when you have to factor in an investment portfolio. If you trade stocks and options, you’ll know that every action in your portfolio could result in a taxable event. I want to explore some things you should be aware of when you’re managing your own portfolio.
Let’s start by covering the two core principles of how your actions in your portfolio get taxed: It’s through long term capital gains, or short term capital gains.
What is a gain?
A gain means an event where the investment you sold was higher than what you bought it. So for example, when you buy an Apple stock for $100 and sell it for $110, you made a $10 gain. Now when you actually sell something and make a profit, it’s called a “realized gain”. If your portfolio just sits there and grows, and you don’t sell anything, this is an “unrealized gain.”
Short Term Capital Gain - When you realize a gain and it’s one year or less.
Long Term Capital Gain - When you realize a gain and it’s more than one year.
What's the Difference between long term and short term capital gains?
The difference in tax rate between long term and short term is that short term capital gains are taxed as regular taxable income. Just simply think of it like it’s income tax. Long term capital gains taxes are much more lenient.
As of 2020, if you’re filing as single, long term capital gains are not taxed if your income is under $40,000. It’s taxed at 15% if it’s between $40,001 and $441,450. It’s taxed at 20% if it’s $441,451 and over. And of course, you double these values if you’re filing jointly.
Example of Short-Term Capital Gains
Let’s say you bought 1000 shares of MSFT at $207 per share and by the end of the week, sold it all for $210. That’s a $3000 short term capital gain you just incurred. That $3000 is taxable at my income tax bracket as if it were money you made from a full-time job. If you're in the 22% tax bracket, you would owe $660 from the $3000.
Let’s assume that every time you sell those shares, you buy 1000 shares for close to that price. And every time it goes up by $3, you sell them all. If MSFT hypothetically reaches $252 per share right before the year is over, you would have realized a total of $45,000 of short term capital gains, which remember, is taxed like income. In a 22% tax bracket, that’s a $9,900 tax you have to pay.
Example of Long-Term Capital Gains
But let’s say for example you bought 1000 shares of MSFT at $207 and it ends up at $252 a year and a day later and you sold all of your shares at that price. Now it’s a long term capital gain of $45,000. If you made between $40,001 and $441,450, you would owe 15% of this, or only $6,750. That’s a $3,150 savings from the short term capital tax if you kept buying and selling. Pretty huge.
FIFO and LIFO
Let’s go over a term you might have heard when trading stocks in your inventory.
FIFO, or first-in-first-out in trading basically means if you bought 1 share of something per day until you have a total of 100 shares, the first share that you sell is the first share that you bought.
Why is this important?
Some brokerages operate in a FIFO method which means the first batch of stocks bought are the first ones sold. This ensures that you’ll be incurring long term capital gains more so than short term capital gains since the older ones get sold first.
LIFO, or last-in-first-out. The most recently purchased shares are the first ones sold in this system.
Why is this important?
Sometimes, incurring short term gains are unavoidable because you may decide to bail out some, but not all, of your shares sooner than later. Because of this, it may be more profitable to sell the more recently-purchased shares since you have a smaller gain in that area. In the event that your “last-in” shares are greater in value than the current market, you can even strategically incur a loss to reduce the total capital gains realized in the tax year.
How do you offset your gains?
If you’re new to the stock market and you’re thinking, “well, can’t I just sell at a loss when the market dips and immediately buy it back? That will incur a capital loss which I can use to offset my gains right?”
There’s actually a rule around this idea known as the wash sale rule. If you sell all of your shares in a company at a loss, you must wait 30 days to purchase it back if you want to be able to incur a strategic capital loss. This rule is set in place to prevent investors from abusing capital losses.
Everyone would be doing this and very few people would end up paying capital gains. If you want to incur a loss but immediately keep your cash in stocks, you’ll have to sell shares at a loss and with the proceeds of that sale and then purchase a different stock.
For example, say I had shares in Visa and Mastercard, and we’re in a bear market. If I wanted to capitalize on that loss without waiting the 30 days, I can do this by selling all my shares in say, Visa, and taking all of that money to buy Mastercard shares. I can’t sell all of Visa, then buy back Visa shares and claim the loss there.
How are Option Premiums Taxed?
Option premiums are known as capital gains that are only realized if the option expires or if the position is closed at a gain. In other words, let’s say you sell a covered call against 100 shares of Microsoft that you own and you collect $500 for it. If you decide to close the position when the option’s value is at around $100, you put in the bid to buy it at $100 and someone sells it back to you, then you realized a capital gain of $400. Or, in the same example, you collect the $500 premium and instead of closing it, you ride it out until expiration where the call expires worthless. The whole $500 is taxable as a short-term capital gain if it expires a year or under.
Managing taxes in your portfolio can be a little confusing and require a great deal of awareness to make sure you’re not paying more than you should. However, just knowing some of these basic rules can help you get out of potential tax pitfalls. If you’re absolutely unsure of how to handle taxes in this area, remember to talk to a tax specialist to determine how you can manage taxes incurred from your investment portfolio. But ultimately, remember that it’s still better to get taxed and make gains, than to not invest at all.
Now that you know a little bit more about taxes on your portfolio, why not start trading and investing in the stock market if you aren’t doing so already?
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