Day Trading: What Happens After the Big Win?
The Reddit boards have lit up lately with stock tips that have produced incredible rewards for those who were brave enough to participate. Given the extreme moves in a few companies, it makes sense to examine what happens after you ring the register on a winning stock trade.
I feel it only prudent to lead this post with the statement that I do not recommend day trading and any investment strategy should be reviewed with your financial professional before implementation.
Over the past few days, there has been a massive influx of traffic on Reddit thanks to a few well-followed voices. The chatter on these board has rallied the retail crowd to plow their money into a few specific companies that have been ravaged during the current pandemic. As of this writing, two of the biggest gainers, for example, are up over 200% in just over two days. While the causes behind this are just as interesting as the gains, that is not the focus of this article. I want to highlight the tax treatment that these traders could experience when they file their returns for 2021.
Tax treatment of investment accounts
When you buy a stock or bond, you own what is called a capital asset. These assets are specifically defined in the tax code and have very important rules surrounding their operation. The definitions and explanations below are limited to taxable accounts (as of Jan '21) as retirement accounts (401k, IRA, etc.) have their own rules and tax treatments.
A short-term capital gain comes after the sale of a stock or bond that was purchased less than one year prior to the sale. Any gain recognized from the sale is taxed as ordinary income, much like the wages you earn at your job. So, if you bought a stock on Monday at $100, it went to $200 on Wednesday and you sold it, you would owe tax at your personal rate on the $100 gain when it came time to file your taxes in April of the following year.
Options, the derivative instruments that represent the bulk of the force behind the drastic stock moves mentioned earlier, can carry extremely complicated tax calculations. Specialized tax professionals should be consulted when evaluating the implications of these contracts. That being said, simple puts and calls typically fall under the same one-year holding period rule as other capital assets.
As of now, long-term capital gains benefit from very different tax treatment than their short-term brethren. Without getting too far into the weeds here, gains from the sale of capital assets that were purchased more than a year prior to sale can be taxed at 0%, 15% or 20% depending on how much income you create in that particular year. This has the potential to save investors in the higher brackets significant dollars. For a married couple in 2021 with $500,000 of income, as an example, the ordinary rate is 35% and the capital gains rate is 15%. If you're keeping score at home, prudent timing of a stock sale for that couple carries the potential to save over 57% in taxes!
The "net" is your friend
To calculate your the amount of capital gains on which you will be responsible for paying tax, we are able to use losses in the portfolio to offset any gains that have been realized. Short-term gains are applied to short-term losses and the same is done for long-term gains and losses. Then you are able to net the short-term with the long-term to get a final figure. This process presents enormous tax planning opportunities and should be discussed with your financial and/or tax professional(s).
The Bottom Line
While paying tax sucks, it ultimately means that you made money on something. I'm pretty sure no one has ever complained about ringing the register after a 200% gain on a stock. There are likely bottles being popped by the Reddit crowd whose accounts have skyrocket this week. It is, however, important to understand and monitor the tax implications on those gains as they have larger implications that simply dragging down your overall returns.