By Joyce Beebe, Ph.D.
Fellow in Public Finance
For many taxpayers, the tax season that started in mid-February has been anything but ordinary. Over the past year, many individuals made the decision to retire early out of pandemic-related health concerns and started withdrawing Social Security benefits, whereas others lost their jobs and began collecting unemployment benefits. In both cases, these taxpayers may have new, taxable sources of income to report. Additionally, with many workers spending more time at home, the pandemic has led to the rise of online trading — the buying and selling of assets through a brokerage’s internet-based platform. This comes with a whole host of important tax considerations, many of which may be unfamiliar for new traders.
One of the most popular online trading platforms is Robinhood, an app that allows investors to trade stocks, options, exchange-traded funds and cryptocurrency without paying commissions or fees. Such apps have facilitated an increase in the number of retail traders, or those who buy or sell securities for personal accounts. Analysts estimate that over 10 million new retail brokerage accounts were added in 2020, and approximately a quarter of all stock market trades last year were made by retail traders, a 55% increase in the number of trades from 2019. Many new account holders are young and have not invested in the stock market before, nor have they ever traded on their own. This means they are new to the capital gains tax rules, bringing up an important question: Are these new traders ready for tax compliance rules?
Capital Gains Taxes
Arguably one of the most popular platforms among retail traders, Robinhood reported an increase of users from 10 million to 13 million between the end of 2019 and May 2020, half of which (1.5 million) were first time investors. The platform’s users are generally young — the median age of Robinhood users is 31.
Because Robinhood does not allow trading through tax-preferred retirement accounts, investors mostly use their taxable accounts to trade. For investors who made money, the attributes of these profits are considered capital gains instead of labor income — although they could be taxed at the same rate as wages. Specifically, for traders who hold stocks for less than a year — for instance, if a trader purchased and then sold the stock in 2020 — the capital gains are considered short term and are subject to ordinary income tax rates ranging from 10% to 37%.
Typically, taxpayers receive Form 1099 from their brokerage platform, and a copy of the form is also sent to the IRS. As such, if taxpayers fail to include trading-associated gains, the IRS will be able to detect the underreported income.
For taxpayers who did not budget for these taxes, they may be caught off-guard and scramble for making timely tax payments. Unlike for wage income, brokerages typically do not withhold taxes on behalf of investors. To alleviate this issue, practitioners suggest that taxpayers with labor income can withhold additional funds from their paychecks to set aside for the tax payment.
For traders who hold stock for over a year, they are subject to favorable, long-term capital gains tax rates. For instance, individual taxpayers with taxable income of up to $40,000 pay no capital gains taxes, and married couples who earn less than $80,000 also do not owe capital gains taxes. Beyond these tax-free thresholds, taxpayers are subject to a 15% long-term capital gains tax rate until their income exceeds $441,450 for single taxpayers and $496,600 for married taxpayers. Taxpayers with income higher than these levels will pay a 20% capital gains tax rate. An additional 3.8% net investment income tax applies to investment income for single taxpayers with income higher than $200,000 and married taxpayers whose income exceeds $250,000.
For young investors who are still in college, an additional consideration is the kiddie tax. The kiddie tax was intended as an anti-avoidance mechanism that prevents parents from shifting income by giving assets such as stocks or bonds to their children, thus reducing their own tax liabilities. In practice, a young adult who has unearned income including interest, royalties, dividends, rental income or capital gains exceeding a certain amount may be subject to the kiddie tax rules. For a student whose labor income supports less than half of her daily expenses, the kiddie tax rules are applicable until she reaches 24.
The kiddie tax provision is an aspect many young investors are unaware of when it comes to the tax costs of frequent trading. The Tax Cuts and Jobs Act (TCJA) of 2017 made major changes to the kiddie tax calculation; however, the changes were repealed at the end of 2019 as part of the Further Consolidated Appropriations Act. Starting from 2020, the kiddie tax calculation reverted back to the pre-TCJA rules. In other words, a dependent with unearned income that exceeds $2,200 will be subject to the kiddie tax at his or her parents’ marginal income tax rate.
For the not-so-lucky traders who incurred losses, gains can be offset with losses and the net amount will be considered for tax purposes. If they have net losses, the amount can first be used to offset $3,000 of ordinary income for the tax year, and the rest can then be carried forward to reduce taxable income or gains in future years.
Some traders employ the “loss harvesting” strategy to manage their tax liabilities, which essentially entails selling money-losing stocks and using the realized loss to offset gains from other stocks or $3,000 of ordinary income. This strategy is legitimate as long as the transactions do not contradict the wash-sale rules, which prohibit selling a stock and benefitting from the loss deduction, only to repurchase the same or similar stock back within 30 days.
Tax Compliance
The simplicity of online trading may not translate directly to capital gains tax compliance for many new retail traders. For these individuals, the tax reporting rules may appear convoluted, and the tax liabilities may be unexpected. Because of the tech-savvy nature of these taxpayers, they have a tendency of seeking help from online chat rooms or internet discussion forums. Practitioners have cautioned against these types of guidance, which can be helpful starting points, but may not be accurate or may only be applicable to taxpayers under specific circumstances. Depending on new traders’ tax knowledge and the complexity of their transactions, the IRS website (free), experienced friends and families (free), tax preparation software (costs less than $100) or licensed professionals (costs about $300) may be reliable and helpful resources to ensure correct tax reporting.
The discussion about Robinhood and its retail traders would not be complete without mentioning the recent GameStop stock trading frenzy. Part two of this series considers what happened and what kind of tax policy proposals are being proposed as a result.