Some investors may owe more than 50% tax as the tax on day trading is much higher than on other types of investments.
MINNEAPOLIS – App investing is hot right now after some people made millions of dollars selling GameStop stock over the past month.
It inspires a new generation of “day traders” who suddenly have more free time due to the pandemic.
It’s all fun and games when you’re making money, but then tax season rolls around and suddenly it’s not that much fun anymore.
Financial experts say many first-time investors may be surprised by the high tax burden that comes with day trading stocks.
“It could be really surprising,” says Elijah Korver, Great Waters’ financial advisor.
“When a lot of people have such a big profit, in the end they don’t know where to find the money for taxes.”
Korver says first time investors who don’t have a tax plan can easily get into trouble if they’re not careful.
This is because day trading, a term that refers to people who buy and hold stocks for a few hours or days, is taxed at a much higher rate than investors who hold their investments for more than a year.
The IRS divides investment income into two categories: short-term capital gains and long-term capital gains.
Short-term capital gains include money you make on stocks, bonds, or other investments that you hold onto for less than a year.
Long-term capital gains are investments that you hold onto for more than a year.
“Long-term profits are always taxed at a lower tax rate,” explains Korver.
Todd Koch of John A. Knutson & Co. CPAs says that understanding the difference between short-term and long-term investments can save you thousands of dollars.
“Everyone can benefit from knowing how long-term profits are taxed differently,” says Koch.
A good example is considering an investor making less than $ 40,000 a year.
If that person were to invest money in the stock market, the federal tax rate on short-term gains would be 12% per year.
However, if the same person holds the same shares for more than a year, the federal tax is 0%.
“You wouldn’t have federal tax on that person and that could mean a ton of savings,” says Koch.
That investor would still have to pay state income tax because here in Minnesota the tax law does not distinguish between short-term and long-term gains.
However, federal taxes alone can easily save you thousands of dollars if you understand how they work.
Another great example is a look at one of the investors who made big bucks selling GameStop stock when the price went through the roof.
Let’s say this person made $ 1,000,000 for round numbers.
The federal tax rate for this person would be 37%, the highest tax rate there is.
That investor would also have to pay the 3.8% NIIT tax introduced by the Obama administration to fund the Affordable Care Act.
(Koch says this tax only applies to investors who made over $ 200,000 in a year.)
After all, that investor would also have to pay state income tax, which in Minnesota would be 9.85%
When you add these taxes together, you have a tax rate of 50.65%.
So the investor in this scenario would owe more than $ 500,000 in taxes.
This can come as a shock to many first-time investors who didn’t know the tax rate was this high. If they have a full year to spend their money, they may run into some problems when tax season rolls around and there is nothing left in their bank account.
“It is really important that people plan so that they are not surprised,” says Koch.
Day-to-day operations may be fun and exciting, but Koch and Korver agree that investors need to consider their tax obligations when investing money.
While day-to-day trades or short-term gains have the potential to make money quickly, Korver says you end up paying a lot more money on taxes.
Let’s say you made $ 1,000,000 in the stock market and held your investments for an extended period, say two years.
You’d still have to pay state income tax of 9.85% and NIIT tax of 3.8% here in Minnesota, but your federal tax rate would drop to 20%.
Compare that to the 37% for short-term gains and you save 17%.
A million dollars would save you more than $ 170,000 in taxes by simply holding on to your investment for more than a year.
Don’t worry if you are worried about your retirement account.
You don’t have to pay any taxes until you withdraw the funds from your account.
However, if you are using some of these new investing apps and investing now to make money, experts say you should think about your tax obligations so that you are not surprised when the tax season starts next year.