We are expected to pay taxes when we make money. What does that mean when we make money from investing?
Opening up our portfolio and seeing a lot of green can feel like this:
However, we have to consider taxes before we start swimming in cash.
When are we taxed?
All capital gains have the potential of being taxed.
However, not all capital gains are taxed every year. Unrealized gains are exempted from taxes until the asset is sold.
Unrealized gains are also called paper gains due to the marked increases in an account statement (on paper) at the end of every month. Unrealized gains are not taxed because we can lose our unrealized gains if the market goes down.
On the other hand, realized gains are the locked-in earnings after we sell an investment. Thus, all realized gains from the sale of investments, stocks, or property are taxed.
Following the same example above, once we sell our $AAPL share for $360, the $60 becomes realized and taxable. If we had ten shares, we would have a taxable gain of $600.
Different tax rates
The tax rate used to calculate what we owe from selling depends on how long we've held the investment. It can be either short-term capital gains (STCG) or long-term capital gains (LTCG). LTCG is preferred over STCG since the tax rate is lower.
If we bought our ten shares of AAPL on January 1, 2020, and sell the shares on December 28, 2020, the $600 gain will be taxed as ordinary income. The tax rate, in this case, depends on where we fall in the federal income tax bracket.
For most, LTCG is taxed at 15%. However, depending on how much money we make, it could be either 0%, 15%, or 20%.
If we bought our ten shares of $AAPL on January 1, 2020, we would have to wait until at least January 2, 2021, before selling to qualify for a better tax rate.
Repeat purchases and sales
Things get complicated when shares are purchased and sold multiple times. Each purchase will have a cost basis and a purchase date and taxes will be calculated with the cost and date for specific shares.
Note, for the scope of this lesson, we only covered capital gains and tax liabilities owed. Capital losses can also be realized or unrealized in the same manner as capital gains and can be used to deduct from tax liabilities for the year. One thing we need to be on the lookout for is the wash sale rule.
Optimized tax strategies work best when you have an accountant we can trust to help us plan. Unfortunately, keeping track of capital gains and losses is very difficult and time-intensive. Hiring professional help is a good idea here. You can also limit how much you pay in taxes by holding onto investments for the long term before realizing the capital gains.