How Do Taxes Impact Your Stock Market Profits?

6 legal ways to lower taxes and boost returns

Photo by The New York Public Library on Unsplash

There’s a saying in the investment community, “It’s not what you make, it’s what you keep.”

This is referring to the effect that taxes (and also various fees) can have on your returns.

You see, earning strong profits from investing in stocks is great, but it means the tax man will soon be at your door asking for his share.

Investors often forget about the impact of taxes, but they can actually have a large impact on what you make over the long term.

For example, Fidelity shows returns after taxes for the market from 1926–2016:

You can see that taxes shave off about 2% per year in returns, which will add up over time.

There are two big reasons why taxes have such a negative impact on long-term returns.

First, you have to actually give up a portion of your profits every year to taxes, which hurts your overall returns.

For example, if you earn $100,000 in investing profits this year you could have to pay $40,000 (or more) in taxes on it, meaning you really only earned $60,000 in take-home profit.

Second, and less discussed, is that paying taxes reduces the amount of money you have available to invest.

For example, if you have $10,000 to invest in the market, but owe $2,000 in taxes at the end of the year, you’re going to end up with just $8,000 left to grow in the market next year.

A 10% gain next year on your original $10,000 would’ve earned you $1,000. But since you now only have $8,000, a 10% gain will earn you just $800.

So, you lost money when you paid out the taxes and you lost money when your investment capital shrunk.

Let’s walk through some basic concepts related to taxes and stock investing. Keep in mind, I’m not a tax expert and you should consult a qualified tax professional with questions.

Seven Types of Stock Investing Taxes

First, let’s review the different types of taxes you could incur when investing in stocks:

Long-term capital gains
Short-term capital gains
Qualified dividends
Non-qualified dividends
Interest income
Foreign dividends
State investment taxes

Capital gains taxes are the most commonly discussed, but there are other taxes as well.

A capital gains tax is a tax you pay on the amount of profit you made investing in a stock.

For example, if you buy a stock for $20,000 and it goes up to $25,000, you would owe capital gains taxes on the $5,000 gain. You don’t owe taxes on the full $25,000, just the portion that was a gain.

There are two different types of capital gains taxes:

Long-Term Capital Gains: Taxes on capital gains from a stock that was held for MORE than a year. Generally the long-term capital gains tax rate is relatively low, usually ranging from 15% up to 23.8% of your profit, depending how much income you make.
Short-Term Capital Gains: Taxes on capital gains from a stock that was held for LESS than one year. Short-term capital gains rates are generally higher than long-term capital gains rates, since the government wants to reward long-term investors. Short-term capital gains are taxed as ordinary income.

In addition to capital gains taxes, there are taxes on dividends and interest income:

Qualified Dividends: Most dividends are considered “qualified” and taxed the same as long-term capital gains.
Non-Qualified Dividends: Some dividends are considered non-qualified and are taxed as ordinary income.
Foreign Dividends: Some companies based in foreign countries have a tax on dividends paid to U.S. shareholders.
Interest Income: Interest is taxed as ordinary income.

The taxes above all relate to the federal government, but many states also levy taxes on your investment profits.

Here’s a map from the Tax Foundation which shows the top tax rate on capital gains by state

Note that each figure is combining the maximum federal rate with the maximum state rate for long-term capital gains:

When you add up all the different types of investment taxes levied at the state and federal level, it can really put a dent in your investing profits.

However, there are several strategies to reduce your tax burden and increase profits.

Ways to Reduce Capital Gains Taxes and Increase Profits

While taxes can create a substantial drag on your long-term investment returns, there are some steps you can take to reduce your taxes.

These are all perfectly legal strategies that many investors use regularly.

Tax-Loss Harvesting

When you sell a stock for a loss, you’re allowed to place the amount of the capital loss against your capital gains to avoid paying taxes on them.

In addition, if you have more capital losses in a given year than capital gains, you can carry forward those extra losses to place against future capital gains.

Let’s look at an example from Fidelity:

In 2008, the investor took a $10,000 net loss on their investment and it become a carryforward loss which displaced capital gains for years to come.

They didn’t have to pay a capital gains tax until 2012 despite realizing capital gains for four years in a row.

Many investors will do tax-loss harvesting at the end of the year, which involves looking through their holdings to see if there are any stocks with losses they’d like to sell in order to offset capital gains.

One thing to keep in mind when tax loss harvesting is the wash sale rule, which doesn’t allow you to claim a capital loss on a stock if you buy the same stock 30 days before or after the sale.

Hold Stocks for a Year or Longer

One of the easiest ways to reduce taxes on your investments is to hold winning stocks for at least a year. This will ensure you pay the lower long-term capital gains tax instead of the higher short-term capital gains tax.

If you want to sell a stock with a big gain that you’ve held for almost a year, you may want to consider the tax benefits of waiting just a little longer to sell so that you pay less in taxes.

Quickly Sell Losers and Hold Winners

Combining the power of tax-loss harvesting and long-term capital gains, some investors are eager to sell big losing positions (for a tax-loss benefit) while holding winning positions for at least a year.

That way they’re constantly building up their capital losses while deferring any capital gains until they qualify under the lower long-term capital gains rate.

Buy Stocks in Tax-Free Retirement Accounts

There are several types of retirement accounts that allow investments to grow tax free. This means you don’t owe any taxes on capital gains, dividends, or interest.

J.P. Morgan shows the power of using a retirement account for tax-free growth:

They estimate that the value of tax deferral in the example above is roughly 0.7% higher average annual returns over the time period.

Examples of tax-free retirement accounts include 401Ks, 403(b)s, Traditional IRAs, SEP IRAs, Roth IRAs, Health Savings Accounts (HSAs), various pensions, and more.

Donate Your Shares to Charity

If you have shares that have amassed a large capital gain, you can donate them to charity.

This allows you to take a charitable deduction on your taxes and the charity can sell the shares and keep the profits without having to pay taxes.

Move to a State with Lower Investing Taxes

One simple strategy to reduce your investment taxes is to move to a state with lower capital gains taxes.

While the bulk of investing taxes usually come from the federal government, some states also add on quite a bit of additional taxes.

How Taxes Impact Your Stocks: Lesson Summary

While taxes are an inevitable part of investing, understanding how to invest in a tax-efficient way can earn you big rewards over the long term.

Let’s review the important takeaways from this lesson:

Taxes reduce your returns because you pay out cash from your profits which reduces how much money you have available to invest.
There are at least seven different types of investment taxes: Long-term capital gains, short-term capital gains, qualified dividends, non-qualified dividends, interest income, foreign dividends, and state investment taxes.
A capital gains tax involves handing over a portion of the net profits you made from investing.
There are several strategies to reduce your investing taxes, including tax-loss harvesting, holding winning stocks for at least a year, owning stocks in tax-advantaged accounts, donating shares to charity, and relocating to a more tax-friendly state.

Disclaimer: This article is provided for informational or educational purposes only and is not any form of individualized advice. All information is obtained from sources believed to be reliable but cannot be guaranteed for accuracy or completeness. Use this information at your own risk.