With investing exploding in popularity among young people this year — fueled in part by COVID-19 and the rise of online trading platforms like Robinhood — many new traders are seeing profits for the first time. So, with tax season quickly approaching, some new investors may be wondering much to set aside for Uncle Sam.
Capital gains (your profits from selling investments) may or may not be considered taxable income. Even with robo-investing platforms like Robinhood, you may be subject to filing taxes on the money you have invested.
But how do you know if you have to pay taxes on your investments? And how much? I know what you’re thinking: Skip the college lecture and just tell me the basics.
There are a variety of factors that determine how your profits will be taxed. But don’t let questions about taxes keep you from investing — here are some tips you need to be informed, gain confidence, and stay proactive.
How Do Taxes Work in a Brokerage Account?
Investment income is taxed differently than your normal wages or even side hustles. Investment income isn’t taxed with social security and medicare costs like regular income.
However, once you sell an investment or even an individual stock, you will be responsible for the full tax implications, since there is no tax withholding at the point of sale. So it’s important to set aside money for taxes when you decide to sell your investments.
Realized Gains vs. Unrealized Gains
Only realized gains get taxed. An unrealized gain is when you buy a stock for $25 per share, and it goes up to $50 per share. The unrealized gain is $25, but you only pay taxes on that profit when you sell.
Realized gains are profits on your investment. After selling your investments, your capital gains are “realized” and you will owe taxes according to the amount of profit and how long you owned the investment.
Short-Term Capital Gains
Short-term capital gains are the outcome of selling capital assets (such as stocks) that you owned for only one year or less.
The short-term capital gains tax rate is calculated the same way your regular income is taxed. The rate can range from 10% to 37%, depending on how much income you accumulated in the calendar year.
Long-Term Capital Gains
Long-term capital gains are the outcome of selling capital assets that you have owned for more than one year.
The long-term capital gains tax rate is determined by your level of taxable income at 0%, 15%, or 20%. The average tax rate on long-term capital gains is 15% or lower.
Pro tip: You can almost always make a higher profit by holding onto the same assets for more than a year. Most taxpayers don’t have to pay the highest long-term rate.
Even the most experienced traders lose sometimes. If you have realized losses (also referred to as capital gains losses) from investing, you can use those losses to reduce your tax bill in the following ways:
- Capital losses can offset the tax you owe for capital gains, which reduces your taxable income.
- If you only have capital losses (no capital gains), you can use the losses (up to $3,000 per year) to offset tax owed for taxable income (such as your salary)
Understanding Investment Tax Forms
Form 1099-B: Proceeds from Broker
This federal tax form records customers’ gains and losses during each tax year. You will receive this form (already filled out) from your brokerage company. Form 1099-B should also include a description of any investments, purchase date and price, sale date and price, and any gain or loss.
Form 1099-DIV: Dividends and Distributions
Form 1099-DIV is a tax record that a company or entity paid you more than $10 in dividends. You would receive this form from your brokerage firm if you earned more than $10 in dividends on your investments.
Form 1099-INT: Interest Income
A 1099-INT is sent by banks, brokerages, mutual funds, and other financial institutions. You will receive a 1099-INT if you received at least $10 of interest income in the calendar year. This interest is considered taxable income and must be reported on your taxes.
Keep your financial documents organized so you can be proactive and engaged in your investments. Consider seeking out advice from a CPA or financial advisor, who can provide current information on tax responsibilities, before you sell investments or sign off on your taxes.