Become a better investor
Lesson in Course: Investing basics (advanced, 3min )
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.
A capital gain is when our investment has gone up in value. However, not all capital gains are taxed.
An unrealized gain is a potential profit that exists on paper, resulting from an unsold investment.
It is also synonymous with paper gains due to the marked increases in an account statement at the end of every month. Brokerages are now all-digital, and the term paper gain is becoming antiquated. We have unrealized gains if we lose money when the market goes down. For example, let's assume we bought a share of AAPL at $300 per share, and the current market value is $360 per share. We have $60 in unrealized gains because if AAPL drops to $290 per share tomorrow, we would have lost our gains.
On the other hand, realized gains are the locked-in earnings after we sell an investment. Thus, all realized gains from 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. And if we had ten shares, we would have a taxable income of $600.
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.
STCG tax is applied when we sell a stock or asset within one year since we purchased it.
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 of us, LTCG is taxed at 15%. However, depending on how much money we make, it could be either 0%, 15%, or 20%.
To qualify for long-term capital tax treatment, we need to hold our investments for over a year. So, for example, 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.
Things get complicated when shares are purchased and sold multiple times. Here's a new example.
When we sold two shares of AAPL in February, only one of our shares, purchased in January 2019, qualifies for LTCG treatment. The other share still falls under the STCG tax ruling. So the taxes we owe are $80 in LTCG and $60 in STCG. At the same time, we are also sitting on $40 worth of unrealized gains from the repurchases. So when we sell those shares, we could add to our STCG taxes owed for the year.
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.
If we owe any capital gains taxes, this lesson on tax documents lets us know which docs to keep an eye out for when filing in April.
Optimized tax strategies work best when we have an accountant we can trust to help us plan. Unfortunately, for most of us, keeping track of capital gains and losses is very difficult and time-intensive to do ourselves. So instead, we should consider long-term buy-and-hold strategies for now.
When our investment had gone up in value from when we bought it
The profit or loss we made when we've sold our investment
The profit or loss that is "on paper" in our account. It becomes realized once we sell the investment.
When we've sold an investment within one year of buying it. The gains are taxed as normal income
When we've sold an investment more than one year of buying it. The gains are taxed at a lower rate than short-term capital gains