It’s that time of the year again, where everyone is closing the previous year (financially) and preparing for the tax season. As stock investors, we know that we have to pay taxes on our capital gains from our stock trading. In this post, I will explain for first time stock traders how much taxes they should pay on their profits, and when they have to pay taxes on their stock gains…

Let me first start by debunking a very common myth (or belief) that seems to worry many first time investors: “I have to pay taxes on my gains, regardless if I sell my shares or not, once the year is over”. Most first time traders think this way: If they bought, let’s say, 1000 shares of AAPL in the beginning of 2011 at around $350 a share, then in their tax return of 2011 (that is done in early 2012), they have to pay taxes on their gains (that amount to around $75,000 if we assume that AAPL last close price in 2011 was $425). This is incorrect, you only have to pay taxes on your stock gains if you sell your stocks. So, if you don’t sell these AAPL shares in 2011, you don’t have to pay a dime in taxes. The only thing that you have to pay taxes for is dividends (you should note that sometimes, taxes are deducted by your broker – think like “deduction at source” – when it comes to dividends). Now, let’s say that you sell only half your position in AAPL, and your profit from that sale is $37,500. This means that you only have to pay money on the gains from the sold portion of your shares, which is $37,500.

Now, let’s say that you have purchased 100 shares of NFLX at $300 each. When the stock hit $100 a few months ago, you felt frustrated, and you sold half your position, for a total loss of $10,000 (50 shares x $200 loss/share). This means that you can claim $10,000 as a capital loss on your tax return. You can’t claim capital loss for the unsold portion of your shares.

So, in other words, you only have to care about the sold portion of your portfolio when it comes to taxes (whether you’re declaring capital gains or you’re claiming capital losses).

Now, how much taxes do you pay on your capital gains from the stock market?

Now that we have established when you have to pay taxes on your capital gains from the stock market, let’s discuss how much taxes you should pay…

In order to know how much you should pay, you should ask yourself, am I a long term investor or a short term investor? This question is crucial as the IRS classifies investors as short term or long term investors and taxes them on their capital gains accordingly. Long term investors pay considerably less taxes than short term investors (it seems that the IRS want taxpayers to be long term investors): long term investors don’t pay any taxes if they fall in the 15% tax bracket (or lower), and they pay a flat tax rate of 15% if they’re anywhere above the 15% tax bracket. So, if you’re a long term investor, and you have sold shares for a total profit of $20,000, and your tax bracket is 35%, then you will only pay 15% of your capital gains on stocks, which is $3,000.

Short term investors, on the other hand, pay taxes according to their tax bracket. For example, if a short term investor falls in the 35% tax bracket, and has made $10,000 in capital gains from the stock market in 2011, then he has to pay $3,500. (notice that you are paying more taxes than what a long term stock investor is paying for double your capital gains)

Now, you might be wondering by now who is a short term investor and who is a long term investor? Well, a short term investor (from IRS perspective) is one who holds a stock for less than a year, and a long term investor is someone who holds a stock for more than a year. For example, someone who bought shares on October 15^th, 2010 and then sold them on July 15^th, 2011 is considered to be a short term investor. Now if someone bought shares on December 10^th, 2010 and then sold them on December 28^th, 2011, he is considered to be a long term investor.

To sum it all, if you are a short term investor, then you pay taxes according to your tax bracket, if you are a long term investor, then you don’t pay any taxes if you fall in the 15% or below tax bracket, and you only pay 15% on your capital gains if you belong to anything above the 15% tax bracket.

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