The Day Trader and Investor’s Guide to Taxes 2022-2023
When it comes to taxes, there are different rules and regulations that apply to different types of income. Let's take a look at the United States tax code as it applies to various forms of investment income.
What Are Capital Gains?
Capital gains refers to the profit you make from selling an asset, such as stocks, bonds, or real estate. When you sell an asset for more than you paid for it, the difference between the sale price and your purchase price is your capital gain.
The US government taxes capital gains, and the tax rate you'll pay depends on how long you held the asset before selling it.
If you held the asset for a year or less, your capital gain will be considered short-term, and you'll pay taxes at your ordinary income tax rate.
However, if you held the asset for more than a year, your capital gain will be considered long-term, and you'll pay taxes at a lower rate.
Do you pay more tax on short term capital gains or long term capital gains?
The tax rates for long-term capital gains are generally more favorable than those for short-term capital gains.
In fact, if you single file and made less than $41,675, you may not have to pay any taxes on your long-term capital gains at all.
What is an example of short term capital gains?
Suppose you bought 100 shares of ABC Corp. for $1,000 on January 1st, 2022, and you sold them for $1,500 on July 1st, 2022. Since you held the shares for less than one year, this would be considered a short-term capital gain.
Assuming you're in the 24% tax bracket, you would owe taxes on your short-term capital gains at your ordinary income tax rate, which could be as high as 37%.
In this case, you would owe $185 in federal income taxes on your $500 capital gain.
What is an example of long term capital gains?
Now let's consider the same scenario, but with a different holding period. Suppose you bought the same 100 shares of ABC Corp. for $1,000 on January 1st, 2020, and you sell them for $1,500 on January 1st, 2022.
This would be considered a long-term capital gain since you held the shares for more than one year.
If you're in the 24% tax bracket, you would owe taxes on your long-term capital gains at the long-term capital gains tax rate, which is currently 15% for most taxpayers.
In this case, you would owe $75 in federal income taxes on your $500 capital gain.
As you can see from these examples, the difference in tax rates between short-term and long-term capital gains can be significant. Holding onto an asset for more than one year can result in substantial tax savings, making it a more attractive option for investors who are looking to maximize their profits.
It's important to note that not all forms of income are taxed as capital gains. For example, if you earn a salary from your job or receive interest income from a bank account, that income is generally not considered capital gains and is taxed at your ordinary income tax rate.
Taxes on Day Trading
If you make a profit from day trading or swing trading stock options, that income is considered capital gains and is subject to capital gains tax.
The tax rate for capital gains depends on your income and how long you held the options.
If you held the options for less than a year, your profits will be taxed at your ordinary income tax rate. If you held the options for more than a year, your profits will be taxed at a lower long-term capital gains tax rate.
Taxes on Stock Trading
Profit from selling stock: When you sell stock for a profit, that income is also considered capital gains and is subject to the same capital gains tax rates as stock options.
However, if you held the stock for less than a year, your profits will be taxed at your ordinary income tax rate, and if you held it for more than a year, you'll be taxed at the lower long-term capital gains rate.
What is a Wash Sale? Why do Day Traders need to be aware of the Wash Sale rule?
A wash sale is when you sell a stock or option for a net loss, then turn around and buy the same stock or option within 30 days.
Traders might do this to create a tax deduction for the loss, but the IRS has rules in place to prevent investors from taking advantage of this tactic.
Wash Sale Example
Here's an example to illustrate how a wash sale works using AAPL stock. Let's say that you own 100 shares of AAPL stock that you purchased for $150 per share, for a total cost of $15,000.
A few months later, the stock price drops to $100 per share, and you decide to sell your shares to realize a loss of $5,000.
However, instead of walking away from the investment, you decide to buy back the same 100 shares of AAPL stock within 30 days of the sale, when the price has dropped to $90 per share.
This transaction is considered a wash sale, and the loss of $5,000 cannot be used as a tax deduction.
The reason that a wash sale is disallowed as a tax deduction is because it's seen as an attempt to game the system. By buying back the same stock shortly after selling it at a loss, the investor is essentially trying to claim a tax deduction for a loss that they haven't truly realized.
It's important to note that wash sales can also occur when an investor buys a similar security to the one that was sold at a loss. For example, if an investor sells AAPL stock at a loss and then buys stock in a company that competes with Apple, this could also be considered a wash sale.
How are Index Fund profits taxed?
If you make a profit from selling ETFs or index funds, this income will be taxed as capital gains. Depending on whether you held the asset for shorter or longer than 1 year will determine the capital gains tax rate.
How are Stock Dividends taxed?
When you receive a dividend payment from a stock, that income is taxed at your ordinary income tax rate. Qualified dividends, however, may be taxed at the same lower rates as long-term capital gains.
Dividends are a form of investment income that are paid out to shareholders of a company.
Regular Dividends and Tax
Ordinary dividends are taxed as ordinary income, which means that they are subject to the same tax rates as your other forms of income, such as your salary or wages.
This means that the amount of tax you pay on your ordinary dividends will depend on your income tax bracket.
Qualified Dividends and Tax
On the other hand, qualified dividends are taxed at the long-term capital gains tax rate, which is generally lower than the ordinary income tax rate.
To be considered a qualified dividend, the dividend must meet certain requirements, including being paid by a U.S. corporation or a qualifying foreign corporation, and being held for a minimum amount of time before being paid out.
What is the difference in tax for ordinary and qualified dividends?
Here's an example to illustrate the difference in tax treatment between ordinary dividends and qualified dividends.
Let's say that you own 1,000 shares of XYZ Corporation, and the company pays a dividend of $2 per share. If the dividend is considered an ordinary dividend and you're in the 24% tax bracket, you'll pay $480 in taxes on your $2,000 dividend income.
However, if the dividend is considered a qualified dividend, you'll be subject to the long-term capital gains tax rate, which is generally 15% for most taxpayers. In this case, you would pay only $300 in taxes on your $2,000 dividend income, resulting in a significant tax savings.
It's important to note that not all dividends are eligible to be considered qualified dividends. For example, dividends paid by real estate investment trusts (REITs) are typically not considered qualified dividends, and are instead taxed as ordinary income.
How are Special Dividends taxed?
Special dividends are payments made by companies to their shareholders in addition to regular dividends. These payments are typically treated as ordinary income and are taxed at your ordinary income tax rate.
How are REITs Taxed?
If you make a profit from investing in a real estate investment trust (REIT), that income is generally considered ordinary income and is taxed at your ordinary income tax rate.
However, a portion of the distribution may be classified as a return of capital, which will reduce your basis in the investment.
Do you pay taxes on shorting a stock?
Shorting stock is the practice of betting that a stock's price will fall. If you make a profit from shorting a stock, that income is also considered capital gains and is subject to the same capital gains tax rates as stock options and individual stock sales.
It's important to note that tax laws can be complex, and this is just a general overview of how the United States tax code applies to different forms of investment income. It's always a good idea to consult a qualified tax professional or use tax software to ensure that you're correctly reporting your investment income and taking advantage of any tax deductions or credits that may apply to you.