One of the top questions I get asked as a trader is: “How does trading affect your taxes?”
And with April 15th just having passed us by… now is the perfect time to talk about it.
Let’s dive in deep and take a look at what taxes have to do with your trading, capital gains, and all that good stuff!
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As a disclosure: I am not an account and therefore cannot give tax advise. If you need specific questions answered, ask your tax preparer or accountant.
How are you taxed as an investor and stock trader?
Capital gains – the category that stocks and and options fall under.
There are two types of capital gains:
1.) Short-term capital gains –
Any capital gain that you have had that has taken place in one year or less. For example, if you bought a stock at $7 and sold it for $50 within 365 days or less – you would have a $43 taxable capital gain.
These are taxed as ordinary income. Your tax bracket is indicated by however much you make by working your 9-5 job. Ordinary income can be taxed as high as 38%. Your capital gains can be taxed at 38%… which doesn’t sound like a lot until you start making big money. Every 100K you make you give back $38,000. That is a big amount of money!
2.) Long-term capital gains –
Any type of stock or option trade that took place over a year of time. You bought it and held it for at least one year before you decided to sell it.
You could be taxed at 0% if you make less than $36,000/year. Taxed at 15% if your bracket is $38,000-$425,000/year. And the MOST you can be taxed at with long-term capital gains is 20%, no matter how much you make.
That is a HUGE difference – from 38% with short-term capital gains down to 15% with long-term capital gains.
Why does this matter?
Depending on the amount of money you are making, it may be VERY important to you.
This all keys into your game plan with trading.
If you know you do not need the money you are trading – you may be inclined to keep your trades for over a year to cut down on your capital gains taxes.
Let’s say you trade $1M account – you may not need all of that to live, right? You may keep your trades for longer term to not be taxed at 38% if you do not need that money.
Obviously if you think your trade is going to turn around and go down, you would want to get out of your trade because at that point you care about salvaging the trade rather than taxes.
Always be able to pay taxes on a gain rather than make a decision in your trade that turns into a loss just to save on taxes.
If the trade is looking good and no problems are on the horizon, you put yourself in a position to save taxes with money you don’t even need right now. Your strategy can be protect your money for another year.
This is where options strategies are so important and come into play –
Because you could actually buy put options at the current strike price. Meaning you could make more money if the stock goes up, but if the stock falls you would be locked into that price. You bought protection where you profit is locked in.
Stay tuned for our upcoming series on option strategies or click here to check out our free webinar about option trading.
As an example –
Let’s say you have entered a trade on January 1st, 2019 and have been in it for 5 months and have made $500K. You may have that be taxed as high as 38%.
You could buy a 7-month put option for the rest of the year. This protects your account for the rest of the year to ensure you do not have that high of a tax rate.
What I really want you thinking about –
Consider staying in a trade for it to become long-term capital gains OR buying a put option to protect your account.
When your account is big enough, you need to learn this nuisances so you can keep more money in your account.
Writing Off Losses
Let’s take the opposite view now… perhaps you are not making money this year so far but you have accrued some losses.
Most people may not know…
…you can only write-off $3,000 of a loss
I used to think I could write the difference off of my losses and only owe of what I made money off of.
NO!
You can only write off $3,000 of a loss.
As an example, let’s say your account is up big during the year but as the year progresses you start to lose money. It may be smart to close out the trade and re-enter so you can clock that loss in the same calendar year.
If you are up $130K from January to May and you sold your trades – it’s on the books.
Now you enter new trades in May and as you come to the close of the year, you are down $100K but you haven’t sold the loss yet and locked it in on the books. If you don’t sell and take that loss – the government will only see the $130K you made earlier that year. They will not see the $100K loss you are now suffering from.
You will have to pay taxes on $130K even though you actually only make $30K with the loss of $100K.
So it may be beneficial to take the loss NOW in the calendar year to reflect that loss.
When traders start to take their losses near the end of the year, this is called “Tax selling”.
On the flip side…
If traders are up BIG, you will see people waiting to sell in January. They wanted to take their money off the previous year… but they knew it would count as a “taxable event” and they want to wait to deal with their taxes the following year.
Good news about writing-off a $3K loss
The good news is: there is something called a “carry forward”. This means you get to carry the remaining loss (minus the $3K) forward to the following years.
For example:
If you lost $100K this year and can continue trading next year, you can only deduct $3K. Which means you have $97K that you can actually carry forward.
So if in 2020 you have a great year in the stock market, and make $300K – you get to write-off that $97K loss from the previous year.
Instead of you paying tax on the entire $300K you made in 2020, you would only pay tax on $203K.
Here is the key –
This is a LONG TERM game! Don’t give up.
When you don’t give up and you keep at it – you can carry the loss forward! Once things turn around and you make profit, you can build a cushion against taxes!
You keep carrying that loss forward until you swallow up the entire loss.
Until you become net-profitable across all of the years you have been trading, you will always have a “carry forward”.
Think about this: some people get upset because certain businesses haven’t paid certain taxes in years. BUT if that business LOST a ton of money years ago, they may still be carrying that money over.
Some people start trading or start a business and quickly give up. So they never get to experience the back-end “success” – what to do with taxes, making money back, etc.
When you look at the game, make sure you’re looking at it in its entirety.
Look at the long-term benefits!
Trading as a business vs. as an individual
I am going to share with you what I personally decide to do. That does not mean that I think everyone should follow the same path or make the same decisions. And again: I am NOT a tax account. You need to consult with a professional before you make these decisions.
Here’s what I do not want to happen –
I do not want you to hold up on getting started because you are frozen with the decision of whether you should trade as a business or as an individual. Which is why I am sharing with you what I do…
When I first started trading in the stock market, I was trading as an individual.
As an individual, there aren’t many benefits…. minus the fact that it is so SIMPLE to get started. There aren’t many “rules” you need to follow.
Once I started to make multiple six figures in my trading account, I considered trading as a business.
My company invests my money for me – but I am the CEO making the directions where the trades and investments should go.
What are the benefits of trading as a business?
1.) You can protect yourself from “robinhoods” (people who take from the rich and give to the poor). If someone tried to sue me as an individual, I don’t own much. The company owns the assets and stocks. I am not saying it’s 100% proof… but this is what I have found.
2.) Allows you to write some things off. I use my phone to trade, I get new Macbooks and Mac computers every year, dual monitors, etc. and some I am able to write-off because I need it as a business for my client (myself).
Although there are benefits – it also is a little more complicated…
As a business, you have to get an LLC or an S-Corp, file the paper work, every year you have to renew it. There is a little more work – and you need to weigh the cost.
This is why I don’t suggest starting with it – you just need to get started.
Then you can think about how to protect your money.
When you have a business account…
The business account may not be given as many tools as you would as a retail investors (individual account) because they consider you as a “professional account”.
The workaround:
Have a business account AND a personal account.
I use my personal account only for research and to gain access to all of the best tools. Then I actually place my trades under my company account.
All my accounts are linked. So it is just a click of a button I can switch back and forth.
The bottomline:
I want you thinking about the different ways that taxes work in respect to capital gains and different entities you can trade under.
If you are brand new to the stock market and are trying to figure out how everything works – check out our blog post and free 10-page PDF Download “How to Get Started in the Stock Market” by clicking here.