Lesson 7 of 7
Costs and taxes, before you start
Fees, spreads and taxes all come out of a return before you count it, and how long you hold changes how much.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A commission, a bid-ask spread and a tax on any gain all come out of a return before you get to count it.
- A gain held one year or less is taxed as ordinary income. Held longer, it gets the lower long-term rate.
- Dividends are taxed too, and a wash sale postpones a loss you were counting on.
An index's quoted return is a return before your costs. Four things routinely take a bite out of it: a commission or fee, the bid-ask spread, a tax on any gain, and a tax on any dividend paid along the way.
What a $1,000 gain keeps, held short term or long term
- Held one year or less, at an assumed 24% rate$760
- Held more than one year, at an assumed 15% rate$850
Four costs, one return
Commissions are the most visible cost, and often the smallest. Many US brokers now charge none on a standard stock trade. The bid-ask spread, covered in how a trade happens, is paid on every trade whether or not it appears on a statement. Then come the two tax costs: one on any gain when you sell, and one on any dividend paid along the way, in the year each is received.
One more layer: your state
Federal tax is only one layer. Most states that tax income apply their own tax to the same gain, on top of the federal one, and state rules do not always follow the federal line at one year.
How long you held it changes the rate
Held one year or less
- Any gain is taxed as ordinary income, at your regular tax rate.
- The same rate that applies to a salary or wages.
- IRS Tax Topic 409 calls this a short-term gain.
Held more than one year
- The gain qualifies for the lower long-term capital gains rates.
- IRS Tax Topic 409 sets the line at more than one year, not one year exactly.
Sell on the one-year anniversary itself and the gain is still short-term. One more day makes it long-term.
Dividends and the wash sale
Dividends add a second layer. A qualified dividend is taxed at the lower long-term rates. To qualify, you must have held the shares more than 60 days in the 121-day window that starts 60 days before the ex-dividend date. A dividend that does not qualify is taxed as ordinary income.
A loss on a sale offsets your gains, and up to $3,000 a year of other income ($1,500 if married filing separately), under IRS Tax Topic 409. The wash-sale rule in Publication 550 blocks that if you buy the same or a substantially identical security within 30 days before or after the sale. The loss is not gone: it is added to the cost of the new shares and counts when you sell them.
Check yourself
A gain is taxed as ordinary income if the position was held for how long?
- More than one year
- One year or less
- It is always taxed the same way
Show the answer
Answer: B.
IRS Tax Topic 409 taxes a gain held one year or less as ordinary income. Longer than that, the lower long-term rates apply.What does the wash-sale rule disallow?
- A dividend paid within 30 days of a purchase
- A loss, if you buy the same or a substantially identical security within 30 days of the sale
- Any trade placed within 30 days of another one
Show the answer
Answer: B.
IRS Publication 550 disallows the loss when the same or a substantially identical security is bought within 30 days before or after the sale that produced it. The loss is added to the cost of the new shares, so it is postponed, not lost.A $2,000 gain is taxed at an assumed 24 percent short-term rate. How much of it do you keep?
- $1,520
- $480
- $1,760
Show the answer
Answer: A.
$2,000 minus 24 percent of $2,000 is $2,000 minus $480, which is $1,520.Sources
- IRS Tax Topic 409, Capital Gains and Losses, on the one-year line between short-term and long-term.
- IRS Publication 550, Investment Income and Expenses, on qualified dividends and the wash-sale rule.
What this leaves out
- Only federal rules are covered, from IRS Tax Topic 409 and Publication 550.
- The 24 percent and 15 percent rates are illustrative assumptions, not a quote of any bracket or law.
- Tax rules vary by income, filing status and state, and change over time; they are not covered here in full.
- This lesson is not tax advice. A real filing depends on your own circumstances and the law in force when you sell.