When you're trying to make money in the stock market, it's tempting to focus on scoring those big returns and worrying about the tax bill later. But taxes can eat away a huge chunk of your returns, especially if you're a frequent trader. Read on to learn about the mistake that could cost you up to 37% of your returns.
How to avoid a hefty tax bill on your gains
When you sell a stock you've held for one year or less, any profit is considered a short-term capital gain, which is taxed as ordinary income. This means you could pay up to 37% of your returns in taxes, depending on your income bracket.
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However, by holding a stock for at least a year and a day, your profits will be taxed at much favorable long-term capital gains rates. In 2021, long-term capital gains rates are as follows:
| Rate | Individuals | Married couples | Heads of Household |
|---|---|---|---|
| 0% | $0-$40,400 | $0-$80,800 | $0-$54,100 |
| 15% | $40,401-$445,850 | $80,801-$501,600 | $54,101-$473,750 |
| 20% | $445,851+ | $501,601+ | $473,750+ |
Data source: IRS. Chart by author.
The majority of taxpayers will pay just 15% on long-term capital gains. There's a clear advantage to hanging onto assets for at least a year and a day.
Note that calculating your capital gains taxes can get a little more complicated. In a nutshell, you can use losses to offset your gains. If you earned $10,000 on the sale of one stock but you sold another stock at a $3,000 loss, you'd only owe capital gains taxes on $7,000. But the big takeaway is that Uncle Sam favors patient buy-and-hold investing over speculation.
Investing in a Roth IRA is one of the best ways to avoid owing money to the IRS. You'll pay income taxes upfront on the money you invest, but as long as you don't touch your returns until you're age 59 1/2 and you've held the account for at least five years, all those earnings are 100% tax-free.
If you're not eligible for a Roth IRA or you want a tax deduction on your contributions for the current year, a traditional IRA is a smart choice. Any gains you realize in the account are tax-free until you withdraw from the account. Then when you take distributions, the money is taxed as ordinary income.
Should you always wait a year and a day to sell a stock?
There are a few times it makes sense to sell a stock you've bought a year ago or less, even if it means paying a bigger tax bill. If something fundamental changes about a company -- say, it gets acquired -- or you have reason to believe the company's growth will fizzle, it may be time to cash out. Likewise, if you see a better opportunity for long-term investing, it makes sense to sell a stock, even if you haven't reached the one-year mark.
Perhaps the biggest reason to sell is if you need cash. It's best to keep money out of the stock market if you expect to need it in the next few years.
In general, long-term investing produces the best results. The tax savings is just one part of the equation. When you invest for the long term, you're less likely to sell low in a panic after the market dips.
Taxes certainly aren't the most exciting part of investing. But if you don't like forking over your hard-earned gains to the IRS, don't ignore Uncle Sam when you make investment decisions.
