According to Investor’s Business Daily, millennials are trading stocks far more frequently than those in Gen X or Gen Z. This is thanks mainly to brokerages no longer charging commissions and the accessibility to the market that trading apps provide.
While it’s admirable to see younger people embracing their financial future, it does also open the door to other potential money-saving opportunities – mainly in the area of taxes. If you trade stocks outside of your retirement accounts using one of these trading apps, then here’s what you need to know about the way they will be taxed and how the IRS treats this income differently from other types of money you earn.
How Is Income Taxed?
Generally speaking, when you make money from your job, it will be taxed as what’s called “ordinary income”. In the U.S., the federal tax system is a progressive tax system where the more money you earn, the higher the tax rate imposed on the top dollar. This is also called your marginal tax rate.
There are currently seven tax rates or “brackets” as they’re often referred to. Under the Tax Cuts and Jobs Act of Jan. 1, 2018, those rates are:
- 10%
- 12%
- 22%
- 24%
- 32%
- 35%
- 37%
Taxpayers move from one bracket to the next based on their tax filing status (single, married filing jointly, etc.) and the amount of AGI (adjusted gross income) they report on their annual federal tax return. These income thresholds are refreshed by the IRS each year for inflation and can be found here.
Now that interest rates are high once again and banks are offering customers significant payouts on their deposits, many people will be reporting interest income on their tax returns. The IRS treats these interest payments as ordinary income and taxes them the same as your paycheck.
How Are Stocks Taxed?
Unlike the money you make from your job, the earnings you can make from stocks or other equities such as ETFs (exchange-traded funds) are taxed differently.
Long-Term vs Short-Term Capital Gains
The first question is how long you’ve held the equity before selling it.
- If you owned the asset for more than one year, the earnings are considered long-term capital gains and will be subject to long-term capital gains tax rates.
- If you owned the asset for one year or less, the earnings are considered short-term capital gains and will be taxed as ordinary income.
The long-term capital gains tax rates are quite a bit less than those for ordinary income. Currently, there are just three tax brackets:
- 0%
- 15%
- 20%
The income thresholds at which these tax rates start are also more generous than those for ordinary income. For example, in 2024, a single filer earning over $100,525 of ordinary income would find themselves in the 24% tax bracket while the same amount from long-term capital gains would land you in the 15% bracket.
At the beginning of each year, your brokerage should send you tax form 1099-B summarizing which capital gains were long-term vs short-term.
Qualified vs Non-Qualified Dividends
If your equities pay dividends, then a similar question will be asked to determine if the distribution was qualified or non-qualified. In general:
- Qualified dividends will enjoy lower long-term capital capital gains tax rates
- Non-qualified dividends will be taxed as ordinary income.
Similar to a 1099-B, your brokerage should also send you tax form 1099-DIV summarizing which dividends were qualified vs non-qualified.
How to Maximize Your Income for Tax Efficiency
Since long-term capital gains tax rates are so much lower than ordinary income tax rates, it makes sense to derive as much of your income from equities as possible. This is a well-known tax optimization strategy that frequently gets used by the wealthy. High-paid executives and business owners will often forgo traditional compensation in place of something more valuable – stock.
For example, the CEOs of many big-name tech companies will often pay themselves a ridiculously low base salary. However, their actual total compensation including stock options could be worth several millions for the year. Case and point: Mark Zuckerberg of Meta (formerly Facebook) was paid just one dollar as a base salary but received $27 million in total compensation for the year.
This is why top earners and extremely wealthy people are able to pay so much fewer taxes than those in the middle class earning significantly less. Through trading equities and receiving dividends, they have very little ordinary income and therefore aren’t levied as heavily for taxes.
To put this in perspective, a single filer in 2024 earning up to $518,900 for the year would be subject to the 35% tax bracket. Meanwhile, another individual making the same money from their stock portfolio would pay just 15%.
Tax Loss Harvesting
Another useful aspect of the way stocks are taxed is that you also have the ability to deduct losses against your gains. Depending on how your portfolio performed over the year and what was traded, you may be able to lower what you owe the IRS.
For instance, let’s say you took in $60,000 in long-term capital gains and qualified dividends for the year. However, you also sold a few of your positions and incurred a $25,000 loss. In this case, your net gain would be $35,000. Since the long-term capital gains tax rate is 0% for single filers earnings up to $47,025 for single filers in 2024, this means you’d essentially have to pay nothing.
The Ultimate Way to Reduce Your Taxes
While trading stocks inside of a regular taxable brokerage account can be fun, a better way is in a retirement savings account. This could be through an IRA or even an employer-sponsored plan like a 401(k) – if they allow individual stock purchases.
Trades that take place in these accounts aren’t subject to the normal capital gains rules as mentioned above. Essentially, all trading that takes place from within the account is isolated from taxes.
You only have to pay taxes when the money is officially withdrawn from the retirement account. This can be done penalty-free any time after age 59-½. Therefore, if you don’t need the money any time soon, then it pays to grow it from within a retirement account.
The ultimate way to do this is with a Roth IRA. Because Roth IRA withdrawals can be made tax-free after age 59-½, they’re the optimal account to use for stock trading.
If you’re not already, consider funding your Roth IRA each year up to the maximum limit. Review your budget if needed and make spending cuts so that you’ll have extra cash to set aside. In the future when you’re collecting tax-free income from your Roth IRA, you’ll be glad you invested the effort into it now.
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