Investors may be cheering the stock market’s performance over the last year and looking to take a profit from their growing portfolios.
But, doing so could mean they owe Uncle Sam.
The stock market has been on a tear — today’s selloff notwithstanding — since slumping in March 2020 due to coronavirus concerns. On Monday, the S&P 500 doubled its level from the pandemic low, marking the fastest bull market recovery rally since World War II.
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At the same time, a slew of new investors have jumped into the market, many utilizing free or low-cost brokerage accounts.
“When you get to the point where you’re investing in the market, you can’t put your head in the sand about taxes,” said Megan Gorman, an attorney and managing partner at Chequers Financial Management in San Francisco. “You need to be proactive.”
What is subject to tax
It’s important for all investors to know that any gains they make is considered taxable income.
“People think sometimes that they’re going to make a lot of money in this market and that they won’t be subject to the same taxes,” said Sheneya Wilson, CPA and founder of Fola Financial in New York. Instead, profits from sales of stocks as well as any dividends earned are subject to capital gains taxes.
Other assets are taxed, as well. For instance, investors pay capital gains taxes on cryptocurrencies, some bonds and some mutual funds.
“This is surprise unintended income that you might have to report,” said Gorman.
When you might be taxed
If you’re a new trader and are worried you might be hit with a tax bill next year, the first thing to do is to make sure you know where your gains and losses are reported in your brokerage account, said Gorman.
Then, you should also assess what your total adjusted gross income will be at the end of the year.
The capital gains tax can be anywhere between zero and 37%, depending on your income and how long you held the asset, according to Wilson. Taxes on short-term capital gains, or assets held less than a year, are taxed at the same rate as your ordinary income and are generally larger than levies on long-term gains.
For assets held more than a year, capital gains are taxed between 0% and 20% depending on income. The tax rate that most taxpayers see on long-term capital gains is 15% or less, according to the IRS.
Those who have lower incomes, generally $45,000 or less, may not owe the IRS anything, as their capital gains rate will be 0%. People who make more, however, may want to see where they stack up against the next threshold — individuals who have AGI of $80,000 or more may be subject to a 15% capital gains tax rate.
The highest earners, generally those who make more than $440,000 annually, may be subject to a 20% capital gains rate, plus a 3.8% net investment income tax.
One important thing to remember is that your AGI includes all earnings from the year, not just your salary, said Wilson. That means any gains you have also count towards your AGI and could potentially mean a higher tax rate.
It could also mean you become ineligible for other income-based tax benefits, such as the child tax credit, said Gorman. If your income including capital gains exceeds the threshold for the enhanced child tax credit benefit, you may be required to pay back the advanced monthly checks on your 2021 income tax return, she said.
Ways to mitigate a tax bill
If you realize that you have capital gains and could be hit with a tax bill at the end of the year, there are a few things you could do now to offset what you’d owe.
One is tax-loss harvesting, which is basically selling assets at a loss which can then offset your gains, according to Anjali Jariwala, CFP, CPA and founder of FIT Advisors in Torrance, California. These losses never expire and can be carried forward into future years, she said.
Another thing you can do to avoid a bill is to donate stock, according to Gorman.
“If you are a charitable person and your portfolio has increased in value, you can cherry-pick a few stocks to donate directly to charity,” she said. “Then you don’t have to recognize the capital gain and you potentially get a tax deduction, depending on what tax bracket you’re in and if you itemize.”
People looking to begin investing who don’t want to have to worry about capital gains taxes and have longer-term time horizons, such as those who are saving up for retirement, can utilize a tax-deferred individual retirement account, such as a traditional or Roth IRA. These types of accounts won’t incur a capital gains tax, but there are other restrictions for taking out any earnings before retirement age.
“If you’re looking to do a Roth IRA, look at keeping the funds in there to avoid a penalty and then looking at high-growth opportunities for stocks,” said financial advisor Delano Saporu, CEO and founder of New York-based New Street Advisors Group. When you do retire, you can withdraw those earnings tax-free, he said.
If you’d like to take advantage of any of these strategies, it’s a good idea to enlist the help of a tax professional now, Gorman and Wilson agree. There’s still time to tax plan before the end of the year, and many experts have a bit more time now to consult with new clients than they would during the busy tax season.
Capital gains taxes aren’t all bad
For most Americans, and especially those who are investing in the shorter-term, it makes sense to use a regular brokerage account.
While getting hit with a tax bill isn’t fun, it isn’t a reason to avoid trading stocks or other assets if it’s of interest to you, according to Jariwala. If you do think you’ll get a capital gains tax bill, you should set aside money to cover it ahead of time, she said.
And, even if you do get a tax bill, that isn’t a bad thing, Gorman said.
“If you pay tax on a capital gain, it means you made money,” she said. “And that’s the point of investing.”
Disclosure: NBCUniversal and Comcast Ventures are investors in Acorns.