Stock investing can produce income, both in the form of capital gains when you sell a profitable investment and in the form of dividend income. While it's a good problem to have, profitable investing can have some big tax implications.
So why am I writing this for Robinhood investors? After all, the same tax rules apply to all investors, regardless of what brokerage they use to buy stocks. But there are three big reasons Robinhood investors need to know them more than most:
- Robinhood's clientele skews younger, and there's a high proportion of newer investors than on many other platforms. If you're a new investor, we certainly applaud you for getting started. But there are some tax implications of investing that are especially important for newer investors to be aware of before they fill out their next tax return.
- Robinhood doesn't offer IRAs or any other sort of tax-deferred retirement account (though the company hopes to in the future). So if you sell an investment at a profit in a Robinhood account, it's a potentially taxable event.
- Finally, some of the most popular stocks among Robinhood investors have produced huge returns. Just to name a few from the 100 most popular stocks on Robinhood, Zoom, Square, and Tesla are up by 517%, 161%, and 439% so far in 2020. And these aren't even the best performers. It's fair to say that there are some Robinhood investors who could end up with some big investment profits.
With that in mind, here are five things Robinhood investors should familiarize themselves with that can help them make better investment decisions and also help plan for a potential tax bill when filing 2020 tax returns next year.
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1. You don't owe any tax unless you sell
The first tax concept investors need to know is that you don't owe any tax on investments until you sell them, no matter how much they go up. Even if your portfolio has increased in value by $1 million this year, unless you've actually sold stock, the IRS can't touch a penny of your gains. Investment profits on stocks you still own are called unrealized gains, and they become realized gains when you sell.
This is why Warren Buffett pays very little income taxes even though he has an $82 billion fortune -- virtually all of his money is in Berkshire Hathaway stock and he hasn't sold any.
2. There are two kinds of capital gains tax, and one can be much lower
If you sell stocks at a profit, you have what's known as a capital gain, which is a type of taxable income. However, there are two different types of capital gains tax -- long term and short term.
In the eyes of the IRS, a long-term capital gain occurs when you sell an investment that you've owned for more than a year. A short-term capital gain occurs if you sell an investment you've owned for a year or less.
Short-term capital gains are taxed just like ordinary income. If you're in the 22% tax bracket, that's the rate you'll pay on short-term capital gains when it comes to federal income tax. On the other hand, long-term capital gains tax rates are significantly lower -- 0%, 15%, or 20%, depending on your income level.
3. Dividends are taxable income
In addition to the high-growth stocks on Robinhood's Top 100, some of the names are big dividend payers. Walmart, Johnson & Johnson, and Starbucks are just three examples of dividend payers that are widely owned by Robinhood investors.
It's important to know that your dividends are considered to be taxable income even if you choose to reinvest them. Most dividends meet the IRS definition of qualified dividends, which gets preferential tax treatment.
4. Selling losing investments can help lower your tax bill
Unfortunately, not all investments will be winners. However, it's important for investors to know that if you sell stocks at a loss, you can use those losses to offset any capital gains tax you owe on profitable stock sales.
If your losses exceed your gains, you can use the excess to reduce your other taxable income by as much as $3,000 per year. To use losses to offset taxable gains that took place in 2020, you'll need to sell losing positions by the end of the year. This strategy is known as tax-loss harvesting, and if you're sitting on any stock investments that just didn't go your way, keep it in mind as the end of 2020 approaches.
5. Your broker will send you tax forms -- and will also send a copy to the IRS
As a final point, it's important to mention that shortly after the end of the year, Robinhood (or whoever your broker is) will send you tax forms that will clearly show how much your realized investment gains or losses were, how much dividend income you received, and any other important tax figures associated with your investment account. And here's the key point to know -- they also send a copy of this form to the IRS, so don't think you can get away with not reporting your profits.
