Apple and Tesla have had amazing runs this year. If you’d purchased $100 worth of Apple stock on Jan. 2, 2020, by the end of August your investment would have been worth $175.44. As nice as that sounds, you’d have done even better with Tesla, as your initial $100 investment in January would’ve been worth $586.95 by August’s end.
Why does it matter if you’ve owned your stock for more than a year?
Whether you’ve owned your stock for more than a year — even if it’s just a year and a day — makes a big difference when it comes time to sell because of the way that investments are taxed.
Profits from stock sales are taxed as capital gains, and there are two different capital gains tax rates. If you own your stock for under a year, any gains will be classified as short-term ones. Short-term capital gains are taxed at the same rate as any other income. But if you own it for longer than a year, it’s a long-term gain, according to the IRS, and it’s taxed at a reduced rate.
The specific rate you’ll pay on long-term capital gains depends on your income. For 2020:
It’s 0% if you are a single filer with income up to $40,000 or a married joint filer with income up to $80,000
It’s 15% if you are a single filer with income between $40,000 to $441,450 or a married joint filer with income between $80,000 to $496,600
It’s 20% if your income is above $441,450 as a single filer or above $496,600 as a married joint filer
These rates are obviously well below your ordinary income tax rate. For example, a married couple with joint taxable income of $75,000 in 2020 would pay 0% on long-term capital gains but would be in the 12% tax bracket, so could owe up to 12% taxes on short-term capital gains.
And, of course, the higher your tax bracket, the more of a difference this makes. Married joint filers with a combined household income between $414,700 and $496,600, for example, would either end up paying a 15% long-term capital gains rate or a 35% short-term capital gains rate.
Should you hold onto a stock long-term just to avoid higher capital gains taxes?
Holding on to a stock you’ve made a profit on just to avoid being taxed at the short-term capital gains rate makes little sense if you believe you’ll likely lose a good portion of your gains before reaching the one year milestone.
But, ideally, you didn’t invest in Apple or Tesla (or any of your other stocks) just to try to earn a quick buck. Hopefully, you still believe your investments are sound and you’ll be happy to stick with them until at least a year has passed — which will mean you can keep much more of your gains when you eventually decide to sell.
Of course, if you did buy in with the hope of making a short-term profit, your gamble may have paid off this time. But chasing short-term gains is a risky investment strategy not likely to work out well in the long run. It also means losing out on the favorable capital gains tax rate that helps make investment income so valuable. It may not be a technique you want to repeat.
In fact, while the IRS considers holding a stock for just a year and a day to be long-term, most people would do better to follow Warren Buffett’s advice. The Oracle of Omaha famously said that if you wouldn’t be comfortable holding a stock for 10 years, you shouldn’t hold it for 10 minutes.
If you listen to these sage words, you’ll both maximize your chances of profiting on your investments over the long-run and you won’t have to worry about losing a bigger chunk of your gains when they’re taxed at the short-term capital gains rate.
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Gallery: 10 Retirement Quotes on Investing (The Motley Fool)
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