The S&P 500 reached a new record high in 2020, allowing many investors to wake up to portfolio growth that seemed too good to be true. If you invested in a standard brokerage account, you escaped the penalties and contribution limits that come with retirement accounts, but you will encounter one major drawback: taxes.
If you let the temptation of selling your stocks too soon keep you away from the long-term benefits of investing, you'll be on the hook for higher taxes. Fortunately, the 2021 long-term capital gains rates will make patience even more appealing to investors.
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An investment opportunity you don't want to miss
According to data from Pew Research Center, about two-thirds of U.S. adults (65%) don't own any stocks, bonds, or mutual funds outside of retirement accounts. That means most people are missing out on the opportunity to take advantage of the stock market's incredible rise and tap into the possibilities of tax-free income before retirement.
A standard investment account can be your best friend if you want to actively invest in a diversity of stocks, sell your stocks anytime you want, and withdraw funds without penalty. The only thing you'll have to worry about is paying capital gains taxes to the IRS. When you sell a stock at a higher price than you purchased it, you have a capital gain. You are required to pay short-term or long-term capital gains taxes depending on how long you've held the investment. If you held your investment for a year or less, you pay a short-term capital gains rate that mirrors the tax rates on income you receive from working a job, which can be as high as 37%. If you're investing for the long-term (over a year), you'll unlock lower tax rates of 0%, 15%, or 20% based on your income range for the year.
The future is brighter
Most people who hold their investments over a year will pay a 15% tax on their capital gains. In 2021, the IRS expanded the income ranges for each tax rate which will allow more people to enjoy the 0% and 15% tax brackets.
If you look at the chart below, you'll notice that single filers with taxable income between $40,401 to $445,850 and married joint filers between $80,801 to $501,600 fall within the 15% long-term capital gains rate. In 2020, these ranges were narrower -- under under $441,450 (single) and under $496,600 (married filing jointly) to qualify for the 15% tax bracket.
But single filers with an income under $40,401 and married filers with an income under $80,801 get the ultimate present: a 0% long term capital gains rate. As you can see, using a long-term investing strategy can be a smart way to accumulate tax-free profits before retirement.
2021 long-term capital gains tax brackets
|
For single filers with taxable income of... |
For married joint filers with taxable income of... |
For heads of households with taxable income of... |
...this is the long-term capital gains rate |
|---|---|---|---|
|
$0 to $40,400 |
$0 to $80,800 |
$0 to $54,100 |
0% |
|
$40,401 to $445,850 |
$80,801 to $501,600 |
$54,101 to $473,750 |
15% |
|
Over $445,851 |
Over $501,601 |
Over $473,751 |
20% |
DATA SOURCE: IRS.
Don't let taxes eat into your profits
The stock market's meteoric rise following the pandemic lows has some investors on the edge of their seat, waiting for the best time to sell stocks and avoid a potential market dip. But if we've learned anything from the bear market in March, it's this: patience pays off.
During an interview, value investor Mellody Hobson shares advice she received from her business partner John Rogers: "Every game is won with patience." This statement couldn't be truer in 2020. Those who were patient during the pandemic had a chance to capitalize on the shortest bull market in history.
If you invested $1,000 in NIO (NIO 2.30%) stock last September, you could have purchased 500 shares for $2 per share and sold at $50 per share in November 2020. That represents a $24,000 long-term capital gain -- no taxes owed if your income falls within the 0% tax bracket! However, if you sold the stock two months earlier -- before reaching the one-year mark -- and had taxable income of $40,200, you would be in the 22% marginal income tax bracket, paying over $4,600 in taxes because you had a short-term capital gain.
It's not a secret: holding stocks for over a year gives you a sweeter deal on your tax return. With the increase in income ranges for long-term capital gains, you'll have a greater chance of falling into the 0% or 15% tax bracket -- saving you thousands of dollars in taxes and getting you one step closer to the wealth portfolio you've dreamed of.
