Investors who took up day trading last year may have a surprise tax bill in the coming months.
By now, brokerages should have sent out account holders' Form 1099-Bs, which will break down gains and losses incurred in 2020. Investors who sold investments and made gains last year will owe capital gains taxes on them this tax filing season.
If you made money by selling stocks — or another type of "capital" asset, including bonds, real estate, etc. — held for less than a year, then you will pay the short-term capital gains rate, which is the same as your ordinary tax rate and can be up to 37%.
Gains made on stocks held for more than a year, meanwhile, will incur the long-term capital gains tax, which maxes out at 20% but is usually no higher than 15% for most people (you can see what you'd pay, based on your income, here).
Say an investor bought airline stock during the dramatic market dip last spring, then sold it later in the year. While she may have made a healthy profit, she'll owe the short-term tax rate on those gains when she files her return, explains Tony Molina, certified public accountant and senior product specialist at Wealthfront.
The investor won't just owe capital gains taxes. The gains will also increase her adjusted gross income (AGI). That could limit her ability to qualify for certain itemized deductions and tax credits with income limits. This year, it could also impact her eligibility for the next stimulus check.
"If you just entered the workforce and you're making $75,000 per year, and you made $20,000 in gains, you're going from the 22% tax bracket to 24% bracket," says Molina, in a simplified example.
That said, there are ways to reduce your AGI, including by making a deductible IRA contribution or maxing out your health savings account (HSA) if you have one. Any losses you had in 2020, typically up to $3,000, can also offset gains.
Going forward, Molina urges investors to be careful about actively trading. Last year, with its massive market highs and dramatic lows, was a "unique time" that may have proved lucrative for some smart traders. But that luck isn't likely to continue indefinitely.
"The reality is, over the long term, your risk keeps increasing," Molina says of day trading as an investment strategy. "You gotta think long-term."
Even "strong" individual returns can be misleading when the market as a whole did extremely well in 2020, a Wealthfront blog post says. "Earning seemingly strong returns of 30% when the market is up 50% is actually pretty terrible performance," the blog says. Add capital gains taxes on top of that, and the investor in question is in even worse shape.
Instead, it's prudent to focus on creating a diversified portfolio via low-cost index funds, says Mark Steber, chief tax information officer at Jackson Hewitt. In fact, studies have shown, time and again, that routinely investing in passive index funds is a better investment strategy for the average person than stock picking.
"Folks looking for a quick buck are courting disaster," says Steber.
Correction: This story has been revised to correct that long-term capital gains affect a taxpayer's AGI.