A well-rounded portfolio can be a great way to invest and make some extra cash. Like most financial activities, however, trading stocks will affect your income tax. The IRS taxes investment income, but there are many factors that determine exactly how they do so.

A well-rounded portfolio can be a great way to invest and make some extra cash. Like most financial activities, however, trading stocks will affect your income tax. The IRS taxes investment income, but there are many factors that determine exactly how they do so.

What are Capital Gains?

Simply put, a capital gain is any income you earn through investing or selling capital assets. Most people think about their homes or stock portfolios when pondering capital assets, but the true definition is much broader. The IRS defines a capital asset as “almost everything you own and use for personal purposes, pleasure, business or investment.”

So yes, your home and your stocks are both considered capital assets. So are coin and stamp collections, household furnishings, jewelry, gold, silver, and other precious metals. Business and investment properties are also capital assets.

Whenever you sell one of these assets for a profit, you must pay tax on the gain. The exception is your home. You are allowed to exclude the first $250,000 ($500,000 if married filing jointly) of gain from the sale of your primary residence. The amount of gain you recognize on the sale of a capital asset is calculated as follows:

Sale Price – Cost – Improvements

Of course, if you sold the item at a loss, you can use the loss to offset any other gains. The IRS currently limits the capital loss deduction to $3,000 per year but allows you to carry larger losses forward into future tax years.

Long Term Capital Gains

Long term capital gains are simply profits you made selling an asset you held for more than one year. What makes them special is their favorable tax rate. Depending on your tax bracket, the IRS taxes long term gains at 0%, 15%, or 20%. Long term gains count as taxable income, but are taxed more favorably than ordinary income. If you can, it’s better to hold capital assets for a year before selling, so long as doing so doesn’t interfere with other investment strategies.

Short Term Capital Gains

As you may have already guessed, short term capital gains are profits you make selling an asset you’ve owned for 1 year or less. Unfortunately, short term gains aren’t taxed at the favorable capital gains tax rates. Instead, the IRS taxes them as ordinary income, which means you will pay the same tax rate as you do on your wages. When paying tax on stock gains for short term assets, expect to pay between 0 and 37%, depending on your tax bracket.

Taxes on Dividends

You may have to pay capital gains even if you didn’t sell any stock this year. This is because stocks and mutual funds sometimes pay you dividends, which are generally taxable. The good news here is that the IRS always taxes dividends at the preferred long term capital gains rate, even if you have held the dividend-paying asset for less than a year.

Many investors arrange their investment account so that any dividends they receive are automatically reinvested. In this case, dividends trigger two events. One is that you’ll need to pay taxes on the amount of the dividend. Two, you’ll need to adjust the cost basis on whatever asset you invested the dividend into. This is a little confusing, so we’ll give you an example.

To keep the math simple, let’s pretend you purchased a single share of stock in XYZ Company through a mutual fund. You paid $20 for the stock, so your cost basis is $20. You also own a share of ABC stock. ABC had a really good year, so they decide to pay all of their stockholders, including you, $1 in dividends. At your direction, your broker reinvested the ABC $1 in the XYZ mutual fund. Your basis in the XYZ stock is now $21. You also owe tax on the $1 dividend payment.

Taxes on Options Trading

The taxes on options trading are somewhat complicated. In short, stock options give you the right to purchase a company’s stock at a specific price. There are two types of options: incentive stock options (ISOs) and non-qualified stock options (NSOs).

There are no tax consequences to having a stock option. This just means you can buy the stock at a certain price if you wish. It’s not until you exercise the option and actually receive the stock that the IRS pays attention.

There are generally no tax consequences for exercising an ISO stock option. You simply buy the stock at the agreed-upon price and then go on your merry way. You will, however, face tax consequences when and if you sell the stock.

NSOs work a little differently. Exercising an NSO option triggers two taxable events. The first occurs when you exercise the stock option and buy the stock. The point of an NSO is to buy the stock for a discounted price. The result is that you recognize a capital gain as soon as you take possession of it. The amount of the gain is the difference between the price you paid and the fair market value of the stock. Here’s how it works:

Pretend you work for a company called Custom Widgets. They offer you an NSO and you exercise it, acquiring a share of stock from Custom Widgets for $10. On the day you exercise your option, however, the fair market value of Custom Widgets shares is $15. Since you paid only $10, you now have a taxable gain of $5.

The second tax event triggered by an NSO option is the selling of the stock. As is true of ISO stocks, you must pay capital gains when and if you sell the stock for a profit later.

How to Pay Lower Taxes on Stocks With Retirement Accounts

Good accountants are those who can find ways to reduce your taxes by making the tax law work for you whenever possible. They look for places in the tax code that offer favorable outcomes for taxpayers whether the IRS intended the law to work that way or not. While some may call them loopholes, accountants prefer to call them “legally mandated strategies.”

One such strategy is the use of retirement accounts to reduce your tax bill. Stocks held in retirement accounts are subject to retirement account rules. In a traditional IRA, you pay tax on your money later under the theory that you will be living on less money when you retire. This allows you to pay tax on the money when you use it later, hopefully at a lower tax rate. As such you can deduct the money you put in a traditional IRA now on your taxes — even if you got that money by selling stock.

The same strategy works with a 401{k). Once money goes into your 401(k), you don’t pay tax on any growth, interest, or dividends so long as the money stays in your account. Converting a brokerage account into a retirement account is a great and perfectly legal way to reduce your capital gains tax liability.

Brokerage Documents

At this point, it’s pretty clear that in order to calculate your capital gain or loss, you need to know your basis in or the cost of stocks you bought and sold. The idea of pulling all of this information together at tax time might make you sweat a little — especially if you don’t have the receipt from every stock transaction you made during the year. Fear not, as your broker has you covered.

At the end of the year, your broker will send you a Form-1099B. This form will detail all of your stock transactions for the year and lists all of the information you need, including your basis in the stock and its sale price.

Sometimes brokers send a special 1099-B that includes several forms in one. They will, for example, include a Form 1099-DIV if you earned any dividends during the year and a Form 1099-INT if you received any interest. Although it’s a good idea to keep accurate records of your own, your broker should have any information you’re missing.

About Filing a 1040 Schedule D

And now we’ve come to one of the most tedious tax chores ever invented. When filing your taxes, you need to report your capital gains and losses on Form 1040 Schedule D. In order to complete the Schedule D, you first need to fill out IRS Form 8949.

The 8949 asks you to individually list every capital gain (or loss) transaction that you participated in during the year. If your broker was busy buying and selling on your behalf, this can be an incredibly long list. Luckily, you can skip this form if the 1099-B you received from your broker lists all of the required information for each transaction and requires no adjustments. Otherwise, you need to list every transaction.

The only other way to avoid the tedium of listing out every transaction is to keep track of them on a spreadsheet throughout the year. The IRS will accept the spreadsheet in lieu of a completed Form 8949 if it has the required information, including the stock purchase price and ultimate sale price.

Is the Long Term Gain Rate Increasing?

You may have heard rumors that the long term capital gain tax rate is increasing, effective September 13, 2021. We’re happy to report that this increase didn’t happen. The rumor of an increase wasn’t unfounded, however. The United States Ways and Means Committee did propose an increase to 25% for those in the current 20% bracket. This recommendation was never adopted or codified into law, however, so you need not fear a higher tax rate for now.

Pay Less Taxes with Professional Help

At Picnic Tax, we believe that stock gains should add to your portfolio rather than your stress. Navigating the water of capital gains and stock transactions can feel a little overwhelming, especially if you make trades often. The professional CPAs at Picnic Tax are ready to help you properly report the trades you’ve already made and help you plan a strategy for reducing your tax liability on future trade. As always, we look forward to working with you.