• Daniel Snitkovskiy

How Much of Your Capital Gains Do You Owe the IRS?

Do you have a taxable investment account? That is, do you invest money in an account that is not tax-advantaged (i.e. retirement account, HSA/FSA, etc.)? Want to know why they're called taxable investment accounts? Have you heard the term "capital gains" thrown around and are dying to know what that means?


If you answered yes to any of these questions, then this article is for you! 😄 We'll be talking about how taxable investment accounts are, well, taxed (i.e. capital gains taxes). Understanding this will allow you to maximize your after-tax return on investment, which is the actual money that you get to keep after you pay your taxes! 🏦


To ease into the jargon, let's revisit our favorite fake dog-shop: Dosco.


Purchasing a Stock in a Taxable Account

You just heard from your friend that DOSC (the stock ticker for Dosco) is straight 🔥, and want in on the action. Since you've already maxed out your retirement accounts, you figure you should use your taxable account to make the purchase. Before we buy, let's go check the stock price on Loogle Finance (aka fake Google Finance):

From here, we can see that the current stock price is $346.57 per-share. That is, 1 share of Dosco would cost you $346.57. Let's say we buy 2 shares for a total of $346.57 * 2 = $693.14.


Jargon-Check: Cost-Basis

The $693.14 that we just paid for our 2 shares of Dosco stock, in investment lingo, is called the cost basis. Cost basis is essentially the sticker price that you pay in order to acquire ownership of an asset (i.e. stocks, bonds, real estate, etc.) Since 2 shares of Dosco stock cost us $693.14, our cost basis for that stock purchase ended up being $693.14. This number provides a baseline for the calculations we'll be doing later down the line, so it's a super important number to know!


Selling a Stock in a Taxable Account

Let's say a few months go by, and you decide (based on the phase of the 🌝/some market research that you did) that it's time to sell your 2 shares of Dosco and get that 💸💸💸 into your bank account. Let's make our way back to Loogle Finance to see the stock price as you're about to sell:

Holy cow, the price shot up by ~10x 😍. That's a return that'd make the Wolf of Wall Street proud. So if we decide to sell our 2 shares of Dosco at this price, we'll make $3,294.64 * 2 = $6,589.28. How much money did we make? Well, we paid $693.14 for those 2 shares originally, and sold for $6,589.28, so that means we profited $6,589.28 - $693.14 = $5,896.14!


Jargon-Check: Capital Gains/Loss

The $5,896.14 that we made from selling our 2 shares of Dosco stock, in investment lingo, is called capital gains. Capital gains is just the profit you make from selling an asset and is calculated by taking the {total value @ sale} - {cost basis @ purchase}. Capital loss is the flip-side of capital gain: it's how much you lose if the sell price is lower than the purchase price of the stock. That is, let's say the price-per-share was actually $200 when we sold. In that case, we'd have $693.14 - $400 = $293.14 in capital losses.


Calculating Capital Gains Tax

Though it'd be great if we could leave our $5,896.14 sitting in the bank, it's unfortunately not that simple. As we saw in our income taxes article, basically any money you make is subject to income taxes. Just like in regular income taxes, capital gains taxes come in tax brackets, and vary by amount. Let's say our taxable income without adding on the capital gains is $60K. Since we sold our Dosco stock within a few months of purchasing, we have to use our regular income tax brackets to see how much taxes we owe on those capital gains:

If we just look at our marginal tax rate, we'll see that the extra $5,896.14 is going to be taxed at a rate of 22%. That means that we'll actually be able to keep $5,896.14 - ($5,896.14 * 0.22) = ~$4,599.00 after taxes 😢.


Jargon-Check: Short-term/Long-term Capital Gains

The reason we used our regular tax brackets when calculating our capital gains tax is because we sold our Dosco stocks within a few months of purchasing them in the first place. The technical name for this is called short-term capital gains, since you're, you know, only holding the assets for a short amount of time. However, if we'd held our 2 shares of Dosco for more than a year, then that'd count as long-term capital gains. What's the difference? Well, one's short and the other is long! JK, it's actually just the tax brackets we use to calculate how much taxes you owe. If the $5,896.14 was considered long-term capital gains, we'd use the long-term capital gains tax brackets:

Since our income falls in the range of $40,001 - $441,450, the tax rate we'd use for our $5,896.14 would be 15%. That is, our take home pay would be $5,896.14 - ($5,896.14 * 0.15) = ~$5,012.00*, which is ~$400 more than we made with short-term capital gains 😱.


* Note: Nerdwallet has a neat capital-gains calculator that can run the numbers for you!


Offsetting Capital Gains with Capital Losses

Let's say a month before you found out about Dosco, you bought 2 shares of Losco: like Dosco, but for lobsters, at $120 per share. Obviously, nobody's going to want to buy wholesale lobsters as much as wholesale puppies, so this stock purchase turned out to be a bad investment ☹️. After staring at some tea leaves, you've convinced yourself that Losco is a lost cause (at least it has an appropriate name). So you decide to sell your 2 Losco shares a couple of months after you bought them. Here's the stock price when you sell 😫:

Once we sell, we've realized a capital loss of 2 * $50 - 2 * $28.97 = $182.06. Is there a silver lining to this?


Jargon Check: Deducting Capital Losses

There is a silver lining! We can actually deduct (i.e. subtract) our capital losses from our capital gains, thereby lowering how much we actually have to pay in taxes! According to the IRS website, you can deduct up to $3K per year, so our $182.06 loss definitely fits into this! Even if we were over the $3K limit, we could carry-over the losses to future tax years (sort of like a gift card you can spend next year).


If we claim our capital losses, we can shave off $182.06 from our capital gains. Going back to our $5,896.14 short-term capital gains on Dosco, what we end up paying taxes on would actually be $5,896.14 - $182.06 = $5,714.08, which saves us $182.06 * 0.22 = ~$40.00! You could pay your utility bill with that money 😤!


Fun-Fact: If you use a robo-advisor, and they mention having tax-loss harvesting, they're basically just optimizing how they deduct capital losses against capital gains. That is, they'll sell losing assets to offset the gains on winning assets, balancing how much you lose with how much you'll save in taxes.


Conclusion

The two big takeaways to keep in mind with taxable accounts is timing (when you buy/sell) and cost basis (at what price you buy/sell). These two factors will dictate how high your tax rates are, as well as what your options are for using your losses to offset your gains, respectively. If you use a robo-advisor, they'll control pretty much everything here (all except when you eventually decide to sell 😉). If you DIY, then this should be a key part of your strategy if you want to achieve similar returns to robo-advisors because, as we've seen, taxes can take a pretty big bite out of our overall returns 😤. Hopefully this article helped demystify the taxes that factor into taxable investing, and gives you a better understanding of what's happening in your taxable accounts!


Action-Items

This article just covers the tip-of-the-iceberg with capital gains taxes! There are a number of complexities that factor into different situations, and the best thing to do next would be to explore the area that's most relevant to you!

  1. Re-investing dividends? Dividends are taxed the year they're received, and should get added to your cost-basis so you don't get double-taxed. Check out this article for more details.

  2. High Net-Worth? If your MAGI > $200K, you could be subject to an extra 3.8% tax on capital gains. Check out this IRS Q&A for more details.

  3. Want to see your gains/losses without whipping out Excel? Your broker/robo-advisor should send you a Form 1099-B if you sold >$20 worth of shares.

  4. Have a robo-advisor with tax-loss harvesting? Go on their website and read how they do it! They’ll usually have white-papers/blog posts detailing their approach.

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Disclaimer: The content on Young, Not Broke is for informational and educational purposes only and should not be construed as professional financial advice. Should you need such advice, consult a licensed financial or tax advisor.

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