This year has seen an enormous increase in market participation, as investors signed up for brokerage accounts on platforms like Robinhood, Schwab, and others.
With commission-free trades, fractional investing that let you own less than a share, trading apps on phones, CARES Act checks, and pandemic ennui, people turned to the market — often for the first time as barriers to investing entry broke down.
Hayden Adams, director of tax and financial planning at Charles Schwab, has some advice for these new investors.
Taxes are a key consideration for investors in general – and not one that newbies might think about when logging into their brokerage account. Yes, $0 trades are exciting, but don’t forget about taxes — “the biggest expense!” Adams said, or everybody’s “silent partner” as Ritholtz Wealth Management founder Barry Ritholtz puts it.
“The key when it comes to taxes is to not just think about taxes in tax season, because it’s too late” by then, Adams said. “By that time there’s not that much you can do besides contribute to an IRA.” (The IRS lets you contribute to the previous year’s IRA up until tax day, which would reduce taxes if it’s a traditional IRA.)
"I encourage people to think about taxes before a transaction, before you click that sell or buy button,” said Adams.
‘Tax drag’ makes a huge difference
This year saw a lot of day-trading where people held a stock for a short period of time before selling it.
And gains from positions held less than 365 days are subject to short-term capital gains taxes, which treat the gains as ordinary income — not the long-term capital gains tax brackets, which are lower.
“What a lot of people don't realize how much more money they actually have to make to make up for the taxes they have to pay,” said Adams, who calls this “tax drag.”
For a 5% return, Adams said, the tax drag from a short-term sale could easily lower that to a 3.2% return.
The end of the year is coming so this is the last chance
When it comes to tax planning, most of it has to be done before the year is over, Adams said. One strategy that’s very useful is tax-loss harvesting, which has been a marketing point for roboadvisers like Betterment and Wealthfront, which provide the service built in. Essentially, it allows somebody with any sort of losses to use that to offset any gains, reducing the amount of taxes owed.
Though in an ideal world the planning happens throughout the year, an investor with gains could decide to sell a loser before year-end in order to lower the taxes they’d pay on gains.
Investors can use the proceeds to buy something else, and it can even be very similar, like a total stock market fund (VTI) instead of an S&P 500 fund (VOO). (It can’t be the same asset.) Or they can use the money to rebalance.
“Don't hesitate to take losses and use them to your advantage,” said Adams. “You're likely to have losses and tax-loss harvesting is a great way to rebalance to get back to proper risk tolerance.”
A key theme for investors, Adams said, is to know the rules and work within them. “You have some control with this,” he said.
The gist of taxes is that they have to do with gains and losses, which is why Adams tells both new and veteran investors to be aware of their cost basis — how much they bought the security for versus how much it’s currently worth — in their positions. There are a number of accounting systems, and the default one your brokerage provides may not be the right one.
If you bought 1,000 shares of XYZ, they probably weren’t all bought at the exact same price if you bought them over time. When you want to sell shares, the default accounting method is FIFO, or first-in-first-out. Essentially, if you want to sell 100 shares, it’ll choose the 100 oldest to sell. But what if you want shares that were bought at the lowest or highest prices? In that case, you’ll want to pick specific shares to sell that will produce gains or losses.
For that, you’d have to change your cost basis accounting to something else. There are a bunch of options, but “specific ID” is a choice that gives investors the most control since you can select the exact shares you sell. But Adams notes that this level of complication may not be for everyone.
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Ethan Wolff-Mann is a writer at Yahoo Finance focusing on consumer issues, personal finance, retail, airlines, and more. Follow him on Twitter @ewolffmann.
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