As most people with even a passing interest in investing know by now, Robinhood is an online brokerage firm catering to young and novice investors. Its flashy app claims to make trading easier and more accessible, but it also allegedly incorporates behavioral nudges that push users to do more short-term trading.

Because of the app's incentives and its customers' general lack of experience, Robinhood users tend to be very active traders. In fact, the brokerage saw more daily average revenue trades in June than all major incumbent brokers, and more than the combined number of DARTs on E*Trade and Charles Schwab.

Unfortunately, such frequent trading has a number of downsides -- including the potential to be taxed at a higher rate than investors who don't trade as much. 

Man looking at tax form and laptop.

Image source: Getty Images.

Why Robinhood traders may end up over-taxed

To understand why Robinhood investors may lose more of their profits to the IRS, you need to know how you're taxed on profitable investments. When they're in a taxable brokerage account (as opposed to a tax-deferred one), you're taxed in the year you sell. Specifically, you pay capital gains taxes at one of two different rates. Short-term capital gains -- gains on assets owned for a year or less -- are taxed at ordinary income tax rates. But gains on investments owned for a year or more are taxed at a lower long-term capital gains rate.

How much lower? For single tax filers with incomes up to $40,000 and married joint filers with incomes up to $80,000, the long-term capital gains rate is 0%. It's 15% for single filers with incomes up to $441,500 or married joint filers with incomes as high as $496,000, and it's just 20% for high earners above these thresholds. 

Lower tax rates apply to long-term gains because lawmakers want to incentivize responsible long-term investing. The problem is, Robinhood may subtly encourage inexperienced investors to engage in exactly the type of short-term speculative trading these tax incentives are designed to discourage.

Short-term trading typically won't be consistently profitable over time, but in recent months many Robinhood users have been riding the wave of the coronavirus rally. And Robinhood's high trading volume suggests many are pocketing gains by selling shares of stock they're very unlikely to have held for a year or longer. 

Those who sell and owe taxes at higher short-term capital gains rates keep a smaller percentage of their profits. That may not seem like a big deal, since after all, profit is profit. But since speculative trading isn't likely to pay off over the long haul, it means less of a cushion to absorb future losses. 

Of course, you can offset capital gains with capital losses, but that only helps if you either experience the losses in the same year as the gains, or had them in prior years and carried them over. And while experienced investors often engage in tax-loss harvesting and make strategic choices on when to sell losing assets to offset gains, this may not be a common technique embraced by novice short-term investors of the type Robinhood attracts. 

At other brokerages that don't cater to inexperienced traders or provide behavioral nudges to encourage active trading -- and that appear to see far fewer trades because of it -- investors may be more likely to hold their stocks long enough to be taxed at lower rates. Most of these other brokerages also offer tax-advantaged accounts Robinhood doesn't, enabling investors to make pre-tax contributions or tax-free withdrawals and defer taxes on gains, which Robinhood investors can't do.

Of course, if you're a Robinhood investor who made a profit, you may not care that you'll pay taxes at a higher rate than long-term investors. But realize that you're both taking a bigger risk by investing for the short term and giving up the favorable tax rate that's a big advantage of earning investment income.

By contrast, long-term investing maximizes your chances of profitability over the long term and means you'll keep more of those profits rather than owing a big bill to the IRS.