Many new traders likely aren’t aware they are trading in taxable accounts, where each sale has tax effects. (Robinhood customers can’t trade within retirement accounts such as traditional or Roth IRAs, where sales aren’t taxable.) Next year, many will be surprised to receive long tax forms for 2020. With 2020 waning and the recent market selloff raising losses, frequent traders need to plan tax moves now. Here’s what to keep in mind.
•Know the basics. The tax rules for investment income are very different from those for earned income such as wages. No Social Security or Medicare taxes are due on it, and there is no automatic withholding to set aside cash for income taxes. Estimated quarterly tax payments may be due. In taxable accounts such as those offered by Robinhood, each trade can generate either a taxable gain or a loss that can offset a taxable gain. Savvy traders maximize after-tax profits by timing when they sell winners and losers, or by selling one lot of shares instead of another.
•Determine net gains and losses. Figuring the tax on a sale begins with subtracting the asset’s purchase price (plus adjustments in some cases) from the sale price and recording a capital gain or loss. At tax time, the investor adds up gains and losses for the year and then nets them using a tax-law formula based on how long the asset was held before sale. If the trader’s capital gains on sales exceed her losses on sales for the year, she owes income tax on the net gains. If the losses exceed the gains, there is no tax, and up to $3,000 of losses can be deducted against ordinary income like wages. If the trader has losses beyond that, they “carry forward” to offset future taxable gains until they are used up.
•Check your tax rate. It may be higher than you think. Day traders usually aren’t eligible for lower rates that apply to long-term capital gains, because they are for investments held longer than a year. Instead, frequent traders’ net profits typically are short-term capital gains taxed at the higher rates used for ordinary income like wages—a fact many traders overlook. If an investor’s tax rate on a net long-term gain would be 15%, then the rate on a similar short-term gain will likely be 22% or higher, depending on income.
•Beware of wash sales. Most trades in taxable accounts are subject to the “wash-sale” rules. A wash sale occurs when an investor buys a security within 30 days of selling at a loss, either before or after it. In that case, the investor can’t immediately use the loss.
•Don’t forget other taxes. There is a 3.8% surtax on net investment income above certain thresholds: $250,000 for married joint filers and $200,000 for singles. If a married couple has $150,000 of employment income and $110,000 of net taxable gains, then the 3.8% surtax would apply to $10,000. Also be aware of state taxes. California has a top income-tax rate of 13.3% and no reduced rate for capital gains.
•Be careful about claiming trader tax status. A coveted tax break allows some day traders to claim their trading is a bona fide business and deduct expenses—such as for specialized terminals, a home office or tax prep—on Schedule C. If these traders also make a timely election under code section 475(f), they reap other valuable benefits. The requirements for this break haven’t been clarified by the IRS, but they are stiff. Among other things, traders often need to trade for at least four hours a day, for an average of four days a week, and make at least 720 trades a year. Be ready for an IRS challenge, advises Robert Willens, an independent tax analyst. “The IRS jealously guards entry into this rarefied category, and the courts have often ruled against taxpayers,” he says.
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