JumboCash: Let's talk taxes

Benjamin Franklin famously wrote, “in this world nothing can be said to be certain, except death and taxes.” In investing, taxes are particularly important because they have a dramatic impact on how much of a return you actually put in your pocket. In this article, I will explain the capital gains tax, as well as a common strategy to reduce the burden of taxes.

In most accounts, you can trade stocks as frequently as you want without penalty, but you do have to pay capital gains taxes on any profits you incur. Anytime you sell a security that is worth more than when you bought it, you must pay a tax on that appreciation. In accounting terminology, the original price at which you purchase an asset is called the cost basis.

Capital gains taxes depend on three key variables: when you sell the security, your total income and your filing status. The most consequential variable is when you sell the security. If you hold a security for under one year and decide to sell it after there has been a gain, you will pay the short-term capital gains rate (the same tax as your income tax rate). If you hold the security for over a year and then sell, you will pay the long-term capital gains rate, which is less severe than the income tax rate.

The tax rate is determined by your income, ranging from 0% for low-income tax filers up to 20%. So, lower earners can pocket more of their capital gains after taxes, while those who already have a high income are taxed more heavily. 

It is important to note that you only pay taxes on gains after the asset is sold. The terminology used to describe this distinction is “paper gains” (how much a stock has appreciated since you bought it) and “realized gains” (a gain that you incur by actually selling your stock). Hence, you only pay taxes on “realized gains,” not “paper gains.”

I’ve been talking a lot about gains, but the reality is not all of your investments will make money. Don’t panic, though: Investment losses can actually reduce your tax burden. When you sell an investment at a loss, you don’t pay the capital gains tax. (There is no gain for the government to tax!) In fact, the amount you lost on your investment can be used to offset capital gains taxes you incur in the future.

For example, say you incur a loss of $1,000 on a long-term investment (you sell the stock at $1,000 below the cost basis — the price at which you bought it). By selling at a loss, you now have $1,000 of tax loss carryforward. That means that if you sell a stock and incur a capital gains tax of $2,000, you can reduce that tax by $1,000 — the loss you originally incurred. This strategy is known as “tax-loss harvesting.” It is not to be confused with tax evasion — it is a common strategy well within tax law.

Tax efficiency is a crucial element of investing, and tax implications should be taken seriously any time you want to buy or sell an asset. Fortunately, realizing losses in the present can offset future gains, reducing your overall tax burden.