Most western governments tax “investing” vs “trading” at different rates.
We shouldn’t let tax consequences impact our trading and investment decisions in an ideal world. We shouldn’t let the prospect of paying less taxes impact our decision to sell a stock. But we don’t live in an ideal world. Taxes do have an impact on one’s trading/investment strategy.
In general, most governments tax “trading” at personal income tax rates while they tax “long term investing” at reduced rates. We need to keep in mind that not all western countries are the same. There are 2 tax systems in English speaking countries.
U.S. capital gains tax
This is what I love about U.S. capital gains tax law: it is very clear. There’s no bullshit about it.
- If you hold an asset for more than 1 year and then sell it, the profits from that trade/investment qualifies for “long term capital gains tax”.
- If you hold an asset for 1 year or less and then sell it, the profits from that trade/investment are taxed at normal income tax rates (much higher).
Long term capital gains tax is the same rate as qualified dividend income. This is much lower than normal income tax rates. This is capped at 20%.
As you can see, there is a clear government-provided incentive for traders and investors to hold stocks and other assets for more than 1 year. Here’s the simple math.
Let’s assume that a $100 investment turned into $200. So you made a $100 profit (100% pre-tax return).
- If you hold that investment for more than 1 year, you will be taxed at 20%. This leaves you with an 80% after-tax return.
- If you hold that investment for 1 year or less, you will be taxed at 37% (top income tax bracket). You are left with a 63% after-tax return.
- The 17% difference in after-tax returns is nothing to sneeze at.
Now this problem becomes more and more apparent the longer you hold onto an investment. Here’s an example.
- Person ABC buys $100 worth of stock, holds it for 3 years and then sells it for $800.
- Person XYZ trades in and out of the market every few months (less than 1 year). He doubles his money every year. In a tax free environment, he turned his $100 into $800 3 years later.
Here are the tax consequences in the U.S.
- Person ABC gets taxed 20% on his profit. He is left with an after tax return of 560%.
- Person ABC is taxed 37% each year. He is left with an after tax return of 333%.
Notice how long term investor ABC’s after-tax return is 1.68x higher than that of trader XYZ (560/333=1.68). Taxes have a massive impact on long term investment performance.
This is partially why I prefer a medium-long term trading strategy in the U.S. stock market. Taxes kill traders. They can outperform buy and hold investors pre-tax, but they don’t mention their relative underperformance after-tax.
That’s why traders should reconsider their trading strategy. Is it really worth it? Focus on after-tax returns.
Former colonies of the UK (UK, Canada, Australia, Singapore, Hong Kong, etc).
This is where it starts to get confusing. Countries with a legal system based in the English tradition (eg UK, Canada, Australia, Singapore, HK, New Zealand) generally state that “capital gains is taxed at reduced rate vs income taxes”. For example, capital gains is taxed at half the rate of income tax in Australia.
HOWEVER, the way these countries define “capital gains” is wishy-washy.
- In the U.S., any profit from stocks = “capital gains”. The mere distinction comes from “short term capital gains” vs “long term capital gains”.
- This is not true in Commonwealth countries. What counts as “capital gains” is not a hard and fast rule. It is defined on a case-by-case basis. There are some general guidelines, but it’s ultimately up to the government’s revenue agency to decide if your stock should be taxed at reduced “capital gains” rates or income tax rates.
- “Capital gains” is taxed at the reduced capital gains tax rate. But if you are defined as doing “share trading”, you will be taxed at income tax rates. “Share trading” has nothing to do with setting up a legal business to trade stocks. Even retired, part-time individuals can be deemed “share traders”. This is akin to “short term capital gains tax” in the U.S..
- The difference is that the U.S. clearly defines what counts as “short term capital gains ” (i.e. hold the stock for 1 year or loss). Commonwealth countries don’t clearly define what counts as “share trading”.
Here are Australia’s guidelines regarding what counts as “share trading”. Canada, HK, Singapore, the UK, and New Zealand are all very similar.
The question of whether a person is a share trader or a shareholder (i.e. capital gains tax) is determined by considering the following factors that have been taken into account in court cases:
the nature of the activities, particularly whether they have the purpose of profit making
the repetition, volume and regularity of the activities, and the similarity to other businesses in your industry
organisation in a business-like way, including keeping accounts and records of trading stock, business premises, licences or qualifications, a registered business name and an Australian business number
the amount of capital invested.
So what traders in these countries tend to do is trade under their personal account and then file for “capital gains tax”. If the government catches them, they argue in court saying “I’m not a share trader. I’m a shareholder and thus should be taxed at the capital gains rate”.
Sometimes these traders will win the court cases and sometimes they’ll lose. That’s because the law itself is unclear. But it’s clear that these governments still encourage people to hold stocks for longer periods of time instead of shorter periods of time. The longer people hold onto a stock in these countries, the more likely they will be taxed at reduced “capital gains tax rates”.