If you’re a new trader or experienced you might have wondered how your gains are taxed at the end of the year. Yup if you make money, Uncle Sam is going to want a cut. There is one simple trick that you can do to minimize your tax obligation at the end of the year. Before jumping let me explain tax obligation in stocks.
Stocks and other securities are taxed under the capital gains tax. There are 2 major cutoffs for capital gains tax, 1 year which is long term capital gains, and less than a year, which is short term capital gains.
The difference between these are huge. Here is a chart of long term capital gains tax rates.
Let’s illustrate this with an example. Let’s say you bought 100 shares of a stock at $20 and sold at $40 after a year. This nets you a total realized gain of $2000. If you fall within the 15% tax bracket, you would be taxed $300.
Other the hand if you held shorter than a year, this would be taxed as marginal income. This is basically income tax since this is now a current asset. Here is a chart for 2020
So in this example, the same sale you earned in the previous example (Buy @ $20 & Sell @ $40) in under a year would be taxed at your respective tax rate. At 24% this would be $480, this is a net increase of $180. Or 40% over the long term capital gains rate.
This is staggering, but there is a trick you can do to do if you manage to layer in your stocks and plan on holding part of your shares over a long period of time.
If you for example bought 50 shares at $10 and then another 50 shares at $30, you would have an adjusted cost basis of $20 for 100 shares. Suppose you hold the 50 shares you bought at $10 for longer than a year and sold the 50 shares you bought at $30 at $40 in under a year. You would have to pay short term capital gains on the $500 gain. This tax would be $120 at 24%. Then let’s say you sold the 50 shares you bought at $10 at the long term capital gain rate of 15% you would pay a tax of $225. Overall this multi leg trade would have a net tax of $345. This is using a LIFO (Last in First out) Tax allocation strategy.
Alternatively if you follow the FIFO (First in First Out) trade strategy and sold the 50 shares of $10 in the short term capital gains rate of 24%, you would have a tax obligation of $360, followed by another trade of the remainder 50 shares of $30 in the long terms capital gains tax rate of 15% you would accrual a tax obligation of $75. Net total you would have a tax obligation of $435. This would be 26% more than the LIFO strategy.
Overall there is a very simple trick in TD Ameritrade to change this under your Profile
To change this on other brokerages might require more steps
This is a quick change that could potentially save you alot in taxes at the end of the year!