Almost everyone who makes money must get acquainted with the taxman.
That’s the reality dawning on U.S. investors who began buying and selling stocks on apps such as Robinhood last year, when they were cut off from other pastimes during pandemic lockdowns. At least 8 million people opened new brokerage accounts in the first nine months of 2020 — many of them young traders who were dipping their toes into the investing pool for the first time.
Now that these investors realize they could be on the hook for taxes, they aren’t outraged (as George Harrison of the Beatles was when he wrote “Taxman”) as much as confused about the rules.
Chase Alford recently received a notification from Robinhood alerting him that it’s almost tax season. The 19-year-old investor, who ended 2020 with less than $5,000 in net gains, is unsure whether he has to pay up.
“I read up on it and everything that I saw didn’t lead me to believe that I had to pay, however I was at the grocery store or something so I didn’t dive into it as much as I needed to,” said Alford, who got into trading in March when he was stuck at home in Fulshear, Texas.
So what should you know if you made money on your investments last year?
2020 Short-Term Capital Gains Tax Rates
The U.S. tax code penalizes speculative trading by taxing short-term gains at a higher rate than long-term gains. The dividing line is one year: To get the lower, long-term capital gains rate, investors must hold onto a stock for a year and a day. Married couples who earn up to $80,000 pay nothing on long-term capital gains and qualified dividends. Most other middle-class income groups pay 15%, and the top rate for high earners is 23.8%. Short-term gains, meanwhile, are taxed like ordinary income, at a top rate of 37%.
Those who made big short-term gains in the market last year may owe a hefty check to the Internal Revenue Service and, depending on where they live, to their state tax collection agency.
When Americans get paid at work, taxes are usually withheld from their paychecks. Brokerages rarely do the same for gains on stocks and other investments. That can create a headache when taxes are due in April, especially if investors haven’t put enough money aside.
“The biggest misconception most investors have is that they won’t be taxed as long as they don’t withdraw the money,” said Ryan Marshall, a financial planner and partner at ELA Financial Group in Wyckoff, New Jersey. That’s true for individual retirement accounts, or 401(k)-style plans. But any other investment income — from selling stocks and bonds, from dividends, and gains created by mutual funds — is taxable.
The boom in brokerage sign-ups last year means individual investors — known as retail traders — now account for a fifth of stock volume in the U.S., according to data from Bloomberg Intelligence. It wasn’t just a U.S. phenomenon. Trading accounts across the globe tripled from 2019, according to a survey by BrokerChooser. In Japan, online firm Rakuten Securities saw a 25% jump in accounts in nine months, while small investors make up almost two-thirds of trading in South Korea. About one in three people in Saudi Arabia has a brokerage account.
Rise Of Retail Investing
Newbie investors are turning to search engines, tax websites, online communities, family members or CPA professionals for help as the start of the U.S. filing season approaches — on Feb. 12, two weeks later than usual.
“That’s a whole other process that I need to learn,” said Mac Coughlin, referring to his potential tax obligations. “Quite honestly I have no idea about any of it,” the 20-year-old business major at Fordham University said. “I took a small loss over the whole course of the year so in terms of filing and tax returns I do not really understand the process.”
For investors with negative returns in 2020 like Coughlin, trading losses can be turned into larger refunds from the IRS. For other investors, however, filing season may be costly. And traders with gains who ignore their tax obligations could wind up with even larger bills down the road.