What is the ultimate goal of trading? To make money, right? Let’s say you have opened up a brokerage account and have found a profitable trading strategy after a few months. You’ve gotten better at doing research on stocks and reading charts so you think you are ready to start trading with some real money. Disney’s stock looks great to you so you buy 100 shares in your account. In a months’ time Disney’s stock has gone up by 3% so you decide to sell and take your profits of 500 dollars. Congrats, you just made your first successful trade! Now before you go thinking that all of that 500 dollars is yours, just remember that like any other source of money you earn, the government is going to want a piece of it! To describe how taxes work I will first show you this video so Ron Swanson can give you a better understanding.
So as Ron illustrated, the government will come in and take a bite out of some of your profits. How much? Let’s get into detail so you can see.
Going back to our Disney example, let’s say you bought those 100 shares and held them but have not sold anything yet. Those shares have increased in value by 3% and you are up in the position by $500 dollars. At this time, you have what is called an unrealized gain. Unrealized gains are NOT taxable. The very moment that you sell those shares of Disney, that $500 dollars becomes a REALIZED Gain and that IS a taxable event.
At the same token, let’s say that Disney stock went in the opposite direction that you intended; going down in value. You put in a stop loss order if Disney went down 2% as your exit strategy. As soon as Disney touches that and you sell out, you will have a REALIZED LOSS.
Capital Gains Tax
Whenever you sold Disney for a $500 dollar profit it is known as a capital gain and you will have to pay taxes on that money. The tax rate depends on what the investor’s tax bracket is and also how long the investment was held.
There are short-term capital gains and long-term capital gains. If you held Disney stock for less than one year and sold it for a gain than this would be a short-term capital gain. Those gains are taxed at the investor’s ordinary income tax rate. This number you can look-up online depending on how much income you make. I have provided a link below for you to check it out. If you held Disney stock for more than one year and sold it for a gain then it would be considered a long-term capital gain. These gains are taxable at a lower rate than the ordinary income tax rate.
You have to consider that not all of your trades will not be winners and in addition to capital gains you will have capital losses. You may offset capital gains with capital losses although they have to be in the same category as far as short-term or long-term. You may offset up to $3,000 dollars of capital gains with capital losses. If you have more capital losses than $3,000 you are able to carry those losses forward into the next tax year.
Do you remember when we talked about a company issuing out a dividend payment in the article, Myth 1: Only Experts Can Trade Successfully in the Stock Market? If you own stock in a company that pays a dividend you will receive that income payment every quarter of the year. The government wants a piece of that too. Dividends that are paid out are also taxed at the investor’s ordinary income tax rate.
Use this link above to see what tax bracket you are in for 2016. Keep in mind these brackets are subject to change each year so always make sure you are using the most updated edition for the specified tax year.
For the sake of simplicity and making sure you handle things correctly with the government, it is best to consult with a tax advisor. The firm you trade with will send you a year-end tax statement showing you all of the taxable activity in your account. That alone should take a big weight off your shoulders; knowing that you won’t have to keep up with it all.
Like all things in life we want to know the ways in which we can avoid paying money right? If you want to maximize the compounding power of your investments, you want to keep as much of your profits as possible. It’s sometimes hard to do that when the government is looking to eat 40% of your lunch every year! Good news is that there are tax-sheltered vehicles that protect you from paying any taxes on your earnings. I will be covering those vehicles in our next lesson so stay tuned!
Homework: Figure out what tax bracket you are in from the link I gave you. It’s good to know how much you will be paying to the government so you can plan accordingly!
“It’s never too early to learn that the government is a greedy piglet that suckles on a taxpayer’s teet until they have sore, chapped nipples.”-Ron Swanson