To say that the stock market's rally has been impressive over the past few months would be a huge understatement. That's especially true when it comes to some of the most popular tech stocks in the market. Apple (NASDAQ:AAPL) and Tesla (NASDAQ:TSLA) are two in particular that many investors have made big profits on recently, but many other high-flying tech stocks have made investors tons of money in recent months.
If you sold any of your big stock market winners after the recent rally and made a large profit, there could be some big implications when tax time rolls around. Here's a quick guide to what you need to know.
Is your sale taxable?
The first question you need to answer is whether your sale is potentially a taxable event or not. Did you own the stock(s) you sold in a retirement account like an IRA, or did you own them in a standard (taxable) brokerage account?
If you sold stocks you owned in a retirement account, then you don't have to worry -- unless you plan to withdraw the proceeds right away in a tax-deferred account like a traditional IRA. As long as you leave the money in the account, stock sales in retirement accounts are not subject to capital gains taxes, no matter how much profit was earned. For example, I recently sold half of my Apple stock at a substantial profit, but since the position was held in my solo 401(k) account, I won't have to worry about the tax implications until I withdraw money from the account.
So, if you sold stocks at a profit in your retirement accounts, the short answer is that your 2020 tax return won't be affected unless you actually withdraw money.
Long or short term?
Assuming that you owned the stock(s) you sold in a taxable account, the next question is how long you owned them for.
When it comes to capital gains tax, the IRS has two categories: short or long term. Here's the difference:
- Short-term capital gains occur when you sell an asset you owned for a year or less. These types of gains are taxed as ordinary income, just as if you had earned it from a job. In other words, if your marginal tax bracket is 22%, that's the rate you'll pay on short-term capital gains.
- Long-term capital gains occur when you sell an asset you owned for more than a year. Long-term gains get preferential tax treatment, with most Americans paying a 15% rate and 0% and 20% capital gains brackets for low- and high-income taxpayers, respectively.
In addition to these, some high-income investors pay an additional 3.8% net investment income tax regardless of the length of time the investment was held.
Losing investments can offset your gains
It's also important to point out that investment profits aren't taxed on a stock-for-stock basis. The IRS assesses tax on your net capital gains for the year. In other words, investment losses can help offset investment gains.
Consider this simplified example. Let's say that you just sold a bunch of Tesla stock at a $5,000 short-term profit. However, you also sold another stock at a $2,000 loss when the market crashed in March. You'd only have a $3,000 taxable gain.
It's a bit more complex than this. For one thing, long-term losses must be used to offset long-term gains before they can be applied against short-term gains, and vice versa. And even if you don't have any capital gains, investment losses can be used to reduce your other taxable income by as much as $3,000.
Furthermore, when the end of the year gets closer, you could revisit your portfolio to see if you're sitting on any losing investments you might want to sell to reduce your tax bill. This is actually a popular strategy known as tax-loss harvesting, and it can significantly lower your taxes on winning investments.
The IRS knows
As a final thought, you don't have to worry too much about calculating your capital gains by hand. Your broker will send you a tax form (typically a consolidated 1099) that contains your gains and losses, dividends, interest income, and more tax information.
And here's the point you should really know: Your broker sends a copy of this form to the IRS as well. So, the IRS knows when you've made a big investment profit. Don't think that you can just not report it and avoid taxes. Failing to report a big investment gain is a quick way to get audited.