If you casually buy and sell stocks it is important to consider the tax implications of these transactions, since taxes can cut into your profits. Also, you can use these same laws to actually reduce your taxes in certain situations.
What Is Taxed?
When you sell a stock, the profit is taxed, which means that the selling price minus the buying price is reported on your taxes for the year you sold the stock. You are never taxed until you sell.
Capital Gains vs. Ordinary Income
The tax laws favor buy-and-hold investors over "day traders" (those who make frequent stock trades) by charging a maximum of 15 percent tax on profits from stocks that were bought at least a year before they were sold. This special tax rate is referred to as "long-term capital gains." This rate only helps you if your tax rate is 15 percent or higher, which is usually the case for people who own a lot of stock.
If you sell the stock less than a year before you bought it, the profit is taxed as regular income, which can be as high as 35 percent.
A Strategy for Reducing Your Income Tax
On your taxes, losses from stock transactions count against your income just as profits increase them. If you own stock that has gone down in value, and you are looking for ways reduce your taxable income, selling the stock is one way to do so. If you believe that the stock price will rebound, just buy it back the same day, and pay taxes on the profits another year.
This strategy may increase your income tax in a future year, but money now is always more valuable than money later, because you can invest the money today.
There is a limit on the amount you can deduct each year for stock losses, so ask a CPA before you do this.
There are some special cases that are beyond the scope of this article. For example, you can receive further tax breaks if you hold a stock for more than five years and the stock issuer qualifies as an American small business, which means that it has less than $50 million in assets. Also, the tax laws regarding cashing stock options are a bit arcane, so consult a professional in this case.
Just as frequently buying and selling stocks is best left to professionals, so is tax preparation. However, if you are selling stocks and making a profit, make sure to put aside at least 15 percent of the profit for next year's tax bill, or a little more if you bought the stock less than a year a go. That way, you can enjoy your profits without worrying about a tax bill down the road.
Ethan Markowitz is a freelance training and marketing specialist living in Los Angeles, CA. While earning his MBA part-time at UCLA, he consults for several entertainment and hi-tech companies and has a proven track record increasing sales, customer retention, and brand awareness.