Want to enhance your stock portfolio but are afraid of the tax implications? If you want to increase your profit without having to give a chunk back to taxes, there are some secrets you need to know.
All the experts know the ways to gain an advantage on your taxes using specific accounts and types of options.
Don’t ruin your revenue on options trading because you’re not familiar with the taxes involved. Read on to learn important things you need to know about taxes on options trading.
Are There Taxes on Options Trading?
When it comes to paying taxes on options trading, your profits made are going to fall under the type of income referred to as Capital Gains under the U.S. federal income tax law. For example, if you buy an option for $300 and then sell it for $1,000 you have a capital gain of $700.
However, your brokerage firm will also charge you fees for the trade when you sell your options. They could be something like $10, meaning your gain would be $690.
Generally speaking, you should expect to pay some kind of tax on your options. However, there are options trading strategies to consider to reduce your risk.
Plus, even if your taxes increase, you are still gaining some profit on your stock options. This makes it work trying options trading as your profits are more than if you didn’t trade options in the first place.
What Type of Options Are You Trading?
Before you can figure out your U.S. federal taxes, you first have to consider what type of options you are trading. This can determine the amount that is taxable income. Are there taxes on stock options trading? Or index options such as S&P 500, Russell 2000, or Nasdaq 100?
For the most part, individual stock options are going to be taxed 100% as regular income at your short-term tax rate. This brings to light the benefits of index options over individual stock options.
The IRS tax index options are less than individual stocks. That’s because the IRS treats them as “Section 1256 Contracts.” This means that no matter how long you own them, the index options are considered 60% long-term gains and 40% short-term.
You then receive a tax advantage on 60% of your gains. This is because long-term capital gains are less than the normal income rates no matter your income level.
Are Index Options Better?
When it comes to taxes on options trading, index options have numerous advantages. As mentioned earlier, 60% of your index options are considered long-term gains. But index options also make doing your taxes easier.
Your broker will report on the profits or losses of your contracts using a one-page 1099-B. This type of form does not report every single trade but combines them based on the individual index product.
So you may have traded multiple times in the S&P 500 contract but the form would only show what you gained or lost within the contract for the year.
You then report your gains via the IRS Form 6781 which is where the 60/40 split gets broken down. These then move to the Schedule D capital gains and losses.
There’s also the “carryback” election feature that index options offer. This lets you carry back losses up to three years. The idea is to be able to offset gains you made in Section 1256 contracts in those years.
Losses that have not been used can be carried forward.
Trading in a Tax-Advantaged Account
If you are trading options in a tax-advantaged account such as a traditional IRA or Roth IRA. Then you can avoid or eliminate taxes on your options trades. However, these types of accounts will also affect the liquidity and accessibility of this money.
You most likely are unable to touch money from a tax-exempt account until retirement age. Other strict rules need to be followed when using these accounts, otherwise, you could be charged penalties for withdrawing the money too soon.
Traditional IRA vs Roth IRA Accounts
Both the traditional IRA and Roth IRA accounts can give you a tax advantage when options trading. They both require you to follow strict rules when withdrawing or placing money into the account. However, there are some significant differences between the two.
The traditional IRA allows you to defer taxes to a later date. This is also true in the case of an employer-sponsored 401(k), which may also allow you to use for option trades. Although they are rare and referred to as brokerage links, brokerage options, or self-direction options.
The idea of the traditional IRA is that you don’t pay taxes for the income upfront. Instead, you pay taxes once you remove the money at retirement age. Until that time you must keep the money in the account.
Waiting to pay taxes can be beneficial because you will only be required to pay based on your full ordinary income tax rate at that age and income level. This could mean you pay less if you wait. However, there is always a chance that taxes could be higher in future years.
The Roth IRA account is somewhat opposite in that it allows you to pay taxes on the money you put in the account upfront. Then you are not required to pay taxes on income and gains.
You must be willing to keep the money in the account however until you retire. Otherwise, you face penalties. There are also limitations on how much money you can contribute each year.
Longer the Better
If you are unable to contribute to a traditional IRA or a Roth IRA, then keep in mind that the longer the option position was held, the better your tax break.
If the gains on your stocks or option positions were held for more than one year, you could receive long-term capital gains treatment. These are taxed at special low rates such as 0%, 15%, or 20%. This can depend on your other income and may change from year to year.
Amp up Your Income
Now that you know some of the ways to decrease your taxes on options trading, it’s time to start exploring your options. Even though being taxed can bring down your overall profit, it’s still worth the gains you do receive from options trading.
Taxes can vary depending on your unique financial situation. Be sure to consult a professional financial advisor, broker, or dealer to receive personalized tax information for the most accurate results.
