Are you prepared for a tax bill if you hit big on day trading this year?

As a financial planner, let me be clear, I don’t advocate day trading your entire portfolio (I prefer to invest for the long term). I do believe that you should scratch that itch though if you’re tempted by it. Take a couple hundred bucks that you’re willing to light on fire (seriously, you need to be willing to lose it all) and open a brokerage account. As long as you are aware it’s a play account and not your life savings, then roll the dice and have a little fun. What happens if you hit big though? Other than becoming overconfident as a day trader, you will also have tax consequences. A lot of money is being made from the run up on meme stocks lately, are you prepared for the taxes you’ll owe on the gains? Let’s talk about it.

What are capital gains?

A capital gain is when you own a stock and then you sell it for more than you paid for it (cost basis).

In the following examples, we’ll take a look at federal income taxes. The gains will also be subject to your respective state income tax rates. Because every state has their own rules, we won’t address that here.

Short Term Capital Gains

A short term capital gain is any stock held for less than a year and sold for a gain. Let’s see it in action.

Example 1:

You bought 1 share of Peloton (Ticker: PTON) for $145.96 (👈 this is your cost basis) on January 4th, 2021. You sold for $167.42 on January 13th, 2021. 

You have a short term capital gain of $21.46. Congratulations, you’re $21.46 richer! Not so fast. The government wants their share. The gain ($21.46) will be included in your taxable income, and you will pay ordinary income (aka standard income tax rates) taxes on it. 

Let’s say you're a single woman with $120,000 in taxable income from your day job. You’ll be in the 24% tax bracket. That’s $5.15 in this example, so your net gain would be $16.31. Not too shabby. Beware, the taxes are due next year when you file so be prepared for the bill. 

Let’s kick the stakes up a bit in the next example.

Example 2:

You bought 100 shares of Gamestop (Ticker: GME) for $4.63/share on August 17th, 2021. You sold for $347.51 on January 27th, 2021. You have a short term capital gain of $342.88/share, a total of $34,288. Congratulations, you hit a home run! Once again though, the government wants their share.

Continuing with example 1, you’re going to pay 24% on the short term capital gain. That’s a tax bill of $8,229.12 due next year. You’re probably thinking, so what?! I’m still $26,058.88 richer. You’re correct, but the issue is when you don’t know you’re going to owe the $8,229.12 next year when taxes come due. What if you don’t have $8,222.19 available to pay the IRS? The IRS doesn’t take IOUs.

So what’s the alternative to a short term capital gain? Let’s take a look at long term capital gains.

Long Term Capital Gains

A long term capital gain is defined as holding the stock for one year or longer before selling it. There are special rules for long-term capital gains tax rates in 2021:

Long-term capital gains tax rate

Example 3:

You bought 1 share of Peloton (Ticker: PTON) for $30.60 on January 3th, 2020. You sold for $167.42 on January 13th, 2021. You owned the stock for longer than a year therefore you have a long term capital gain of $136.82.

A long term capital gain is taxed differently than a short term capital gain. Using the examples above, you’re a single woman with $120,000 in taxable income and in the 24% bracket. According to the IRS, you’d be subject to a 15% long term capital gain tax rate 

(See table above). That’s a tax hit of $20.52, and a net gain of $116.30.

Once again, let’s kick it up a notch.

Example 4:

You bought 100 shares of Gamestop (Ticker: GME) for $4.32/share on July 19th, 2019. You sold for $347.51 on January 27th, 2021. You have a long term capital gain of $343.19/share, a total of $34,319. This is a similar gain to example 2, but the taxation will be much different, let’s take a look.

On a long term gain of $34,319 you will pay 15% which is $5,147.85 for a net gain of $29,171.15. This is $3112.27 more than example 2 based on how long you held the stock. Which would you rather have?

There is no right or wrong answer, but you need to be aware of the consequences of when you sell your stock. There is a significant difference in the taxation of each circumstance. There are also some options to avoid the big tax bill.

Offset gains with losses

You only pay taxes on the cumulative gains in a calendar year, so if you have a large gain from the sale of a stock then one way to reduce that tax bill would be to sell a stock that has decreased in value for a loss. If the loss is greater than the gain, you can reduce your taxable income by up to $3,000 each year, and carry forward the remaining loss on future tax returns until the loss is depleted.

Save in tax deferred accounts

I wouldn’t recommend day trading in these accounts, but they are a good option for buying and holding long term assets. The gains are not taxed until you withdraw the money, most likely in retirement.

Prepare for the tax bill

Enjoy day trading and still think it’s worth the tax hit? Cool, just prepare for the tax bill. I’m not against playing around in the markets on the side, I just want to make sure you’re prepared for the tax bill. Make sure you estimate the taxes you’ll owe and put it aside in cash so you’re not surprised on tax day next year.

If you’re interested in learning more, schedule a free complimentary call with Assist FP.

Disclaimer: This blog shouldn’t be considered advice, or recommendations. If you have questions pertaining to your individual situation you should consult your financial advisor.