In the second of two years in which complex global events have changed the way many people make their money, and thus the way they pay their taxes, it’s prudent to consider the changes that have taken place and consider which among them might be permanent trends.
Rapidly changing employment statuses and government relief packages of 2020 made life complicated for tax filers and auditors alike last year. The performance of the stock market in 2021 left many unpleasantly surprised this time around. But the popular culture emergence of investing has led to a steadier stream of new investors trying their hand at day trading. As investors continue to experience gains for the first time amid this wave of new investors, some of their behavior might suggest they weren’t aware of the tax implications of their investments.
A Growing Market and a Performing Market
2021 was quite the year to enter the stock market. During the first two years of the Covid-19 pandemic, economic necessity and the allure of rapid returns drove large numbers of everyday people to invest in the speculative side of the market. Others joined because they had expendable cash on hand from stimulus checks and an inability to spend on things like travel. In the spring of 2021, a strong recovery led stock values to increase across sectors.
Stories of overnight success for first-time retail continue to lure even more entrants into the market. Fueled by a media that focused on the rare stories of rapid growth instead of the real story of successful long-term investing, more retail investors joined the bandwagon, buoying the prices of stocks popular among those investors.
Not only are more investors joining the market, but ongoing volatility in the market also can mean that the trading strategies of new and uninformed investors can still lead to rapid profits. New taxpayers will have to learn what it means to report capital gains for the first time. Many of them are likely to be surprised, and some could even find themselves in trouble. It isn’t uncommon for individuals to start investing without understanding how it might impact their taxes later, but it is generally a short-lived problem.
Like touching a hot stove, people learn their lesson and it sticks. Last year, however, there were a lot of people learning that lesson all at once with behavioral and financial consequences that might extend beyond their own finances. Lessons learned from this year could help guide new investors and the tax professionals advising them through this process in the future.
A Tax Season Surprise
When reporting gains for the first time, the highest potential for surprise for underinformed investors is the treatment of short-term capital gains as regular income. Investors who experienced sizable gains may cash out some of their positions to spend the money they made without knowing that doing so turned those gains into taxable income. And unlike income from a job, the taxes on capital gains are not automatically withheld. If those gains were significant enough, they could push an individual into a higher tax bracket. The rude awakening comes when these investors find out they could have held onto far more of it had they only waited a year to sell.
Where the situation can potentially become more dire is when an individual underestimates—or completely disregards, in some cases—tax consequences and spends their gains as though the entirety of the ROI was free and clear. This decision may not have always been made of maliciousness or ignorance. Some enter the market out of necessity due to lost income, meaning they are forced to convert their gains to cash as they come in order to make ends meet. Regardless of whether a person spends taxable income knowingly out of necessity or otherwise, tax season rolls around, and some might find themselves coming up short.
The Role of Behavioral Finance
Cognitive bias among new investors can lead them to take on positions with negative tax implications without knowing it. The disposition effect causes uninformed investors to hastily sell positions that have become profitable while holding onto those that have recently dropped. By doing so, they could be looking at unrealized losses on their books while simultaneously paying taxes on gains.
Biases also play a role in how investors will react to their yearly taxes; the federal government has already acknowledged this to some extent. Loss aversion makes us perceive payments as more important than equal-sized returns. Further, the very act of paying—for anything—inflicts varying levels of psychological pain depending on the payment method used, and it is at least part of the reason why income taxes are automatically withheld rather than charged at the end of the year. Imagine the implications regarding tax law if every employee (and employer) were required to stop by the local tax collector’s office after each pay period to hand over physical dollars.
Capital gains taxes that are suddenly due upon filing would feel like a bigger hit than income taxes withheld, even if they were taxed at the exact same rate, leading investors to feel more deserving and thus more protective of that income.
The planning fallacy can also play a role if someone had a specific use in mind for their investment returns, and specifically the money they lost in taxes on those returns. They may feel even more loss aversion come tax time if they realize their plans have been compromised. This can result in a perceived or actual need for additional funds to achieve a given objective. As more investors this year were doing so to try to get by, it’s more likely that they had planned out the uses for every dollar earned.
Can Trading Platforms Help?
Many people who will be surprised by the tax implications of their investments likely use one of the various platforms designed to make the stock market more accessible, like Robinhood or Acorns. Although they have no obligation to educate their users of the tax implications their investing choices may incur—their purpose is just to facilitate the transaction—these platforms might find a consumer value add by including some level of tax information about their user’s investments.
In the meantime, tax professionals should be prepared to deal with new investors who might be facing uncomfortable tax scenarios for the first time. For a combination of factors, both experienced and psychological, these investors may be increasingly desperate to hold on to as much of their gains as possible, presenting headaches and opportunities alike for those serving them.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Mark Gorzycki and Mahesh Kashyap are co-founders of OVTLYR, a platform designed to deliver timely behavioral insights on the depth and breadth of the US public equity markets. Together, they bring decades of experience in the field of technology, mathematics, and behavioral sciences.
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