It seems like every week now there’s some new speculative investment that’s supposedly “going to the moon.” It was GameStop and AMC a few months ago, now Dogecoin has been having its day in the sun the past few weeks. While I’m all for this newfound interest in the stock market and investing, this short-term game of pumping and dumping certain investments is really just another form of gambling.
Technology and the internet have changed investing. It’s becoming gamified. The money being traded in these investment accounts doesn’t seem real when transactions occur with the push of a button on your phone. Again, I’m all for more access to investing, but it’s a double-edged sword.
Are there people who can make a lot of money day trading? Of course. Are the odds in your favor? Nope.
Listen, I get it; no one likes to hear about the pitfalls of day trading when it seems so fun and lucrative. And I’m not here to tell you how you should or shouldn’t invest. But if you’re going to play the game you should at least know the rules.
One of the most common things I see people forget when talking about their investing adventures is taxes. The only guarantee when trading stocks frequently is taxes.
I mentioned I might do a series of posts on the lessons I learned from trading in my Robinhood account. This second lesson is something I personally didn’t have trouble with because I didn’t trade frequently in my account, but it’s something every investor should know.
Lesson #2: Be aware of taxes
Many first-time investors who hopped into the market last year may be in for a rude awakening when they realize how much they owe in taxes. I’ve read plenty of tax stories recently ranging from the mildly annoying — a trader having 34-page 1099 and having to hire a tax professional — to the outright horrifying where one investor profited $45,000 but had an $800,000 tax bill.
So, let’s dive into the taxes associated with buying and selling stocks. We’ll start with the basics.
A common misconception is you won’t be taxed as long as you don’t withdraw the money from your account. This is only true for retirement accounts, not for regular investment accounts like those held at Robinhood.
Anytime you sell a stock is a taxable moment. Selling a stock for more than you bought it for results in a gain. Any gain you receive is taxable.
How your gains are taxed depends on how long you held the stock. The dividing line is one year. If you bought and sold the stock within a year, you’ll have a short-term gain. If you bought and held for longer than a year, you’ll have a long-term gain.
The U.S. tax code penalizes day trading by taxing short-term gains at a higher rate than long-term gains. Long-term gains are taxed at favorable rates of 0%, 15%, and 20% while short-term gains are taxed at regular income rates of 10% to 37%.
Let’s say you bought shares of stock totaling $1,000 and a couple of months later sold those shares for $10,000. You now have a $9,000 short-term taxable gain. Because you bought and sold within a year, the $9,000 will be added to your income for that year.
If your salary is $50,000, the $9,000 gain also counts as ordinary income so your total gross income would be $59,000. Using current tax brackets for a single filer, that $9,000 gain would be subject to a 22% tax rate or $1,980.
Using those same numbers but selling your shares after one year instead of after a few months presents a different tax situation. The $9,000 long-term gain does not increase your income but instead is taxed at capital gains rates. For a single filer, the $9,000 gain would be subject to a 15% tax rate or $1,350.
The tax system is designed to benefit long-term investors.
To be clear, paying taxes on your investments is a good thing. It means you’ve made money, which is better than the alternative.
Unfortunately, unlike the way taxes are usually withheld from your paycheck, brokerage firms don’t typically set aside taxes for your gains. For this reason, short-term investors could be looking at a situation where they’ve locked in exceptional gains early in the year, only to lose most of those gains in other investments later on making them unable to pay their large tax bill the following spring.
If you’ve been a successful enough trader to warrant a sizable tax burden, it’d be wise to set aside at least a quarter of your gains for the upcoming taxes.
People are free to trade and invest as much or as little as they please. Just make sure you do so with your eyes wide open with the understanding that with day trading the odds aren’t in your favor and it comes with higher tax consequences than a long-term buy and hold strategy.
Thanks for reading!