The subject of taxes is not one of the more exciting topics for most traders and investors. Nevertheless, since capital gains tax can be a significant portion of your gross earnings in the market, it’s important to have a good understanding of its impact on your bottom line. Here, we will discuss the types of capital gains tax, and the tax treatment of different types of financial instruments. Additionally, we will provide some insights on how to structure a trading business for maximum tax efficiency.
Capital Gains Taxes
Many individuals who start out trading the markets spend most of their time evaluating different financial instruments, and pay very little attention to the potential tax consequences of their trading activity. Adding this additional dimension to the equation can sometimes feel overwhelming to some.
However, sooner or later, every trader and investor will have to confront the tax implications of buying and selling within the market. As such, it’s best to try to be aware of these capital gains implications, so that you are not left off guard when the time arises to deal with them.
Our discussion around capital gains tax will be focused on the current rules and guidelines as outlined within the tax code of the United States. Now having said that, and as a point of disclosure, this article should only serve as a starting point from which to analyze your own personal situation, and you should always consult your own tax or financial advisor for specific direction. Our purpose here is to provide you a general framework for the current tax environment as it relates to trading and taxation for US citizens.
So what exactly are capital gains taxes? Essentially, a capital gain is said to occur whenever an individual or entity sells an asset for more value than they originally purchased it for. It’s a fairly straightforward matter to calculate the amount of a capital gain realized. We can illustrate that formula with the simple equation below.
Capital Gain = Selling price of asset minus purchase price of asset
Stocks, bonds, futures contracts, options contracts, foreign-exchange contracts, are all considered capital assets which are subject to capital gains tax. We will be taking a closer look at the tax implications of these financial assets a bit later, but for now, it’s important to know that each is considered a capital asset.
Now it’s important to understand that a capital gain event is only triggered upon the liquidation or sale of an asset. Meaning that, if the asset has appreciated but remains unsold, that appreciation will not trigger a capital gain tax. It will only be classified as a realized gain upon a sale. This is an important distinction that traders and investors should keep in mind.
There are two primary types of capital gains tax rates. The first is considered short-term capital gains, and the second is referred to as long-term capital gains. Short-term capital gains tax rates will generally be higher than long-term capital gains tax rates. Short-term capital gains are incurred whenever you hold an asset for less than one year. And, the actual short term capital gain tax paid will be dependent on your current ordinary income tax rate. Alternatively, long-term capital gains are incurred whenever you hold an asset for a minimum of one year. The actual long-term capital gains tax paid are generally lower and are currently capped at 20%.
Because of this, it is more advantageous from the tax perspective to hold onto positions for the longer-term. However, this is may not always feasible for certain trader groups, particularly, those that specialize in day trading or swing trading time frames. In any case, it’s important to at least realize the inherent advantage to a longer-term position trading approach when it comes to maximizing tax efficiency.
Let’s look at an example of how a capital gains tax might look on a stock sale. We will look at two different scenarios. One wherein the trader holds the position for at least one year, and the second scenario wherein the trader holds the position for less than one year. Additionally, we will assume that the trader’s ordinary income tax rate puts him within the 37% bracket, while his long-term capital gains tax rate is 20%.
Scenario 1 – Sale of stock XYZ held for over one year
- Bought 200 shares at $50 $ 10,000
- Sold 200 shares at $100 $ 20,000
- Capital gain realized $ 10,000
- Capital gain tax at 20% $ 2,000
- Net profit after tax $ 8,000
Scenario 2 – Sale of stock XYZ held for less than one year
- Bought 200 shares at $50 $ 10,000
- Sold 200 shares at $100 $ 20,000
- Capital gain realized $ 10,000
- Capital gain tax at 37% $ 3,700
- Net profit after tax $ 6,700
As we can see, the net profit after tax is quite a bit higher when the stock was held for at least one year compared to a holding period of less than one year. More specifically, the trader could have net gain of $8000 versus $6700 on the same trade. And this additional $1300 profit on the trade was merely a consequence of the differing treatment of the capital gains on the stock sale.
Now, although these rates may change from time to time depending on the economic climate, it is fairly safe to assume that based on historical trends, that long-term capital gains rates will almost always have a more favorable treatment compared to short term trading tax.
Tax on Stock Trading
Most people are familiar with the different types of stocks and Exchange traded funds (ETFs) within the stock market. The equity market is where most individuals started when they became interested in market investing and speculation. The tax that you will pay on your stock holding will depend on your actual holding period.
As we noted earlier, if you hold your stock or ETF position for a period exceeding one year, you will have the benefit of a lower capital gains tax rate. As of current, this long-term capital gains tax rate will depend on your filing status. There are currently three primary types of filing status: Single, Head of household, and Married filing jointly. And so, depending on your filing status, and income level, your long-term capital gains tax rate will be either 0%, 15% or 20% at its upper threshold.
If, on the other hand, you hold your stock or ETF position for a period of less than one year, you will forgo the benefit of the lower capital gains tax rate. Instead, you will incur the higher tax rate which is consistent with your ordinary income tax rate. And again, your ordinary income tax rate will vary based on your filing status, and the income earned for the tax period. This income tax rate is a sliding scale with the highest bracket at 37%.
Now, many people choose to invest in dividend stocks within their portfolio. Dividend stocks payout a certain percentage of their earnings back to their shareholders. This can add an additional layer of complexity to the income tax on stock trading. There are essentially two different classes of dividends, ordinary and qualified dividends.
Without getting too deep in the details, ordinary dividends are the type that most traders and investors will deal with. It is those dividends that are paid out on the common class of individual stock. And as it relates to the tax rate, ordinary dividend payments are taxed at the ordinary income tax rate, which goes up to 37%. Qualified dividend payments, on the other hand, are taxed at the long-term capital gains rate, which goes up to 20%.
Tax Treatment of Futures Trading
Let’s now shift our attention a bit and discuss some of the tax ramifications of trading commodities and another instruments within the futures market. Believe it or not, the tax treatment for futures contracts is much more favorable than that of stocks and ETF’s described earlier.
Futures traders enjoy a hybrid type of capital gains tax rate. More specifically, futures contracts are taxed at 60% long-term capital gains and 40% at short-term capital gains. Per IRS trading rules, commodities and futures transactions are classified as 1256 contracts.
Under this arrangement, futures traders would pay 60% of their realized gain at the lower long-term capital gains rate, and pay the balance of the 40% of the realized gains at the higher short-term capital gains rate based on their ordinary income tax bracket. And this tax structure pertains to any type of futures transactions regardless of the time interval for holding the asset.
So, it wouldn’t matter whether you are a futures day trader holding positions for as little as a single session, or a long-term trend trader who may be holding positions for several months or even several years. In other words, your day trading taxes as a futures trader would be billed at the same rate as a longer term futures trader.
Tax on Forex Trading
Currency trading has become increasingly popular over the last decade. This is true in both the United States, and around the globe. Foreign exchange traders seek to speculate on the exchange rate movements of various currency pairs. As you might imagine, these currency trading transactions will incur certain tax implications.
So what do we need to know about forex trading and taxes? Currency trading transactions are considered within the umbrella of section 1256 contracts similar to futures trading. Under this specific code, gains from foreign exchange trading profits or taxed at the favorable 60/40 method.
We have described the 60/40 tax method earlier. It is an arrangement wherein 60% of the capital gain is taxed at the long-term capital gain rate, while 40% of the capital gain is taxed at the shorter-term capital gain rate. This tax structure helps forex traders to lower their capital gains tax bill. Let’s look at an example of what this might look like.
Will assume that over a period of one year, you have made 150 currency trades in the Forex market. And your average profit per trade was $ 60. So based on this, you would’ve made a profit of $9000 over the course of the year. Let’s calculate what your capital gains tax bill might look like assuming a long-term gains rate of 15%, and your ordinary income tax rate of 32%.
In this case, here is how capital gains would be calculated for your currency trading transactions.
60% of $9000 is equal to $5400, which is to be taxed at the long-term rate of 15%. And so, $5400 × 15% equals $810.
40% of $9000 is equal to $3600, which is to be taxed at the short-term rate of 32%. And so, $3600 × 32% equals $1152.
Adding these two components together, we get a total of $1962 forex income tax in this case.
This would be the total amount of capital gains payable on the $9000 realized profit. If we take this one step further, we can see that the combined effect of this hybrid tax model brings our total capital gains tax rate to 21.8% in this particular case (1962÷9000 = 21.8). As is evident from this example, the structure for forex taxes is quite desirable.
Crypto Trader Tax Treatment
Of all the different financial instruments that can be traded, crypto currencies are the newest class of assets. Their popularity has skyrocketed since 2015. In fact, the gains realized from many different crypto currency coins has been astronomical. Some of these digital coins have seen returns in excess of several thousand percentage points and more over a relatively short period. This is astonishing by any investment measure. Obviously, these gains have come with some very large tax bills for those who were early entrants into the crypto investing arena.
Bitcoin is by far the most widely traded crypto currency in the market. Its average daily trading volume exceeds those of its nearest competitor by a fairly wide margin. So how exactly is Bitcoin and other crypto coin investments taxed?
Well, it’s interesting to note that the IRS considers Bitcoin, for the purposes of taxation, as an asset rather than a currency. As such, these digital coins have a tax structure that is similar to individual stocks and ETF’s.
In other words, Bitcoins held for less than one year are taxed at the higher short-term capital gains rate. And, Bitcoins held for more than a year are considered long-term capital gains, and taxed at the lower rate. One interesting side note which is important to mention here is that since Bitcoin can involve the process of mining, those costs can be deducted as an expense, if they apply.
Tax on Options Trading
Options trading offers many of the benefits of equities trading, but often can be structured so that the initial cash outlay can be substantially minimized. Options traders can buy a put contract if they believe that the price of an asset is going to move lower over a specified period of time, or buy a call option contract if they believe that the price is going to move higher.
Additionally, options sellers, also referred to as option writers can take advantage of mispricings based on their statistical models to potentially profit on their options trade. There are many different types of option strategies that can be employed, and the vast majority of which will be subject to capital gains taxes.
There are essentially two types of options contracts that we need to classify for tax purposes. The first is what is referred to as equity options, and the second is what are known as non-equity options. Depending on the type of options traded, there will be different capital gain tax ramifications.
Equity options refer to options on traditional stocks and ETF’s, exchange traded funds. The capital gains rate on these are treated in the same manner as capital gains on individual stocks themselves. That is to say that realized gains will be taxed at either the longer-term holding rate, or the shorter-term holding rate.
Non-equity options are those that are defined as options contracts that fall outside of the equity market. This includes options on futures contracts, and foreign-exchange contracts. These non-equity options are treated in a special way under the IRS code section 1256.
We presented this tax treatment in the earlier section, but just as a refresher, capital gains tax under section 1256 is calculated using a hybrid taxation rate. That is to say that 60% of any realized gain would be billed at the longer-term capital gains rate, while 40% of any realized gain will be taxed at the shorter-term capital gains rate, which is your specific ordinary income tax rate. Derivates traders should be happy to know that taxation of futures and options on futures work the same way.
Tax Efficient Trading And Investing
Now that we’ve discussed the tax implications of trading in the different types of financial asset classes, let’s shift our attention a bit, and talk about ways to improve the tax efficiency of your trading and investing activities. So what are some legal methods that we can employ to try to reduce the amount of capital gains tax that we incur?
Well first and foremost, we know that if we increase our holding period to at least one full year on the financial instruments that we trade, we will benefit directly from the lower capital gains tax rate. As such, if you are a shorter-term swing trader, you may want to allocate a percentage of your trading portfolio to long-term position trading, wherein you can benefit from a reduced capital gains rate.
In addition to this, we have illustrated that there are certain types of financial assets within the trading universe that offer a better tax treatment than others. Trading Individual stocks, ETF’s, and options on equities are less advantageous from the tax perspective then are futures products, foreign exchange products, and options within these markets. As such, it may make sense if you are primarily an equities trader, to diversify your trading beyond just stocks and equity options.
What if these avenues are not feasible for you, what else might you be able to do to increase your tax efficiency from trading? Well, you’ll be glad to hear that there are certain types of accounts wherein you can defer or even eliminate taxes on your realized gains. What I’m referring to are certain types of retirement accounts. One of the most popular type of investment account where you can completely eliminate any capital gains tax is the Roth IRA.
Within the Roth IRA account you are not taxed on your realized gains even when you withdraw funds from that account. Essentially it’s a tax-free account. The main drawback to a Roth IRA is that there are limits to the amount of funds that you can deposit in that account. Currently that is set at $6000 per year, and is likely to go up in the coming years.
A traditional IRA is similar to a Roth IRA in that you can realize certain tax advantages on your capital gains. A traditional IRA will allow you to take a tax deduction on your contribution into the IRA account, however you will be liable for paying any tax amounts due at the time of withdrawal.
As a result, in most cases a Roth IRA offers a better tax solution for traders and investors than does a traditional IRA. In addition to Roth IRAs and traditional IRAs, traders and investors can look into employer-sponsored 401(k) plans, self-employed retirement account plans, and 529 plans.
Hopefully by now, you should have a pretty good understanding of the tax ramifications of trading different financial products. Although, taxes are an area that is not always top of mind for many market traders, it is nevertheless, a subject matter that traders and investors will ultimately need to deal with.
As we noted, there are ways that you can increase your tax efficiency to reduce your trading income tax. At the end of the day what matters most is not necessarily the amount we make, but rather the amount we keep from our trading business.