Tax Considerations

For 401K or 403b plans, and any IRAs (Roth or regular), you do not have to worry about tax consequences of trading.  All taxes are deferred until you take them out (except for Roth IRAs, which are not taxed on withdrawal).  These tax considerations only apply to your investment accounts.

Generally, you need to think about short-term versus long-term capital gains in your investments and about dividend income.  Short-term gains (or losses) are gains from assets that are sold less than one-year from purchase.  So, if you buy shares of a stock or shares in a mutual fund for $2000 on December 1, 2019 and you sell the asset for $2500 on or before December 1, 2020, you will incur a short-term gain of $500.  Short-term gains are treated as ordinary income and are taxed at your marginal income tax rate.

The marginal income tax rate refers to the tax on your next $1 of income.  You need to be aware of what it is because the IRS uses a graduated income tax system, with the marginal rate increasing as your income increases.  Table 1 shows the current (2020) marginal tax rates.  So, for example, if you are married, file jointly, and together have taxable income of $85,000, your marginal tax rate is 22%.

Table 1:  2020 Tax Brackets and Rates

Rate For Single Individuals, Taxable Income Over For Married
Individuals Filing Joint Returns, Taxable Income Over
For Married Individuals Filing Separate Returns, Taxable Income Over For Heads of Households, Taxable Income Over
10% $0 $0 $0 $0
12% $9,875 $19,750 $9,875 $14,100
22% $40,125 $80,250 $40,125 $53,700
24% $85,525 $171,050 $85,525 $85,500
32% $163,300 $326,600 $163,300 $163,300
35% $207,350 $414,700 $207,350 $207,350
37% $518,400 $622,050 $311,025 $518,400

Source: Internal Revenue Service

Long-term gains are treated differently (Table 2).  If you sell more than a year after purchase, you incur long-term gains.  There is a maximum tax rate on long-term gains which, for most people, is 15% (very high-income earners will pay 20%).  You may pay no capital gains tax at all if your taxable income does not exceed the zero-bracket threshold.  You also need to consider your home state tax rates.  If you are a high earner, the Net Investment Income Tax (additional 3.8%) may apply (see link below).

https://www.irs.gov/individuals/net-investment-income-tax

Table 2:  2020 Long-term Capital Gains Tax Rates

Rate For Single Individuals, Taxable Income Over For Married Individuals Filing Joint Returns, Taxable Income Over For Married Individuals Filing Separate Returns, Taxable Income Over For Heads of Households, Taxable Income Over
0% $0 $0 $0 $0
15% $39,375 $78,750 $39,375 $52,750
20% $434,550 $488,850 $244,425 $461,700

Source: Internal Revenue Service

Most mutual funds, and a good number of individual stocks, will generate dividend income.  Dividend income is divided into Ordinary Dividends and Qualified Dividends.  Whether dividends are qualified or ordinary depends on how long the stock is held.  Because mutual funds buy and sell shares continually, they tend to generate a mix of the two.  Qualified Dividends are taxed as if they are long-term capital gains, as described above.  Ordinary dividends are taxed as ordinary income and will be taxed at your marginal income tax rate.

Generally, long-term gains are preferable to short-term gains, emphasizing the value of investing for the long-term.  On the other hand, if you are in a low tax bracket, the consequences of incurring short-term gains are fairly minor (0 or 15% tax rate).  If you are in a higher tax bracket, then you have to worry more about the difference between short- and long-term capital gains.

Many people use a first-in, first-out (FIFO) approach for selling stocks or mutual funds.  If you sell them all, it does not matter, but if you sell part of your asset (say 50 out of 100 shares), then FIFO will tend to increase the number of shares that are subject to long-term gains, with the more favorable tax consequences, if you are a long-term investor (for day traders, FILO [first-in, last-out] may be more advantageous). 

If you are close to the one-year period and are concerned about the tax consequences of short-term gains, then it may be advantageous to wait until the one-year period passes before selling to lock in the lower tax rate; again, this consideration depends on your tax bracket.  On the other hand, it is better to have a short-term gain than to incur a loss, so do not worry about tax consequences if you think the stock is headed south and there is good reason to sell.

If you sell a stock or mutual fund shares for less than the purchase cost, you will incur a short-term or long-term capital loss, depending on how long you held the asset.  If a taxpayer’s capital losses are more than their capital gains, they can deduct the difference as a loss on their tax return. This loss is limited to $3,000 per year, or $1,500 if married and filing a separate return. If a taxpayer’s total net capital loss is more than the limit they can deduct, however, they can carry it over to next year’s tax return.


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