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Ep 145: Tax Basics and Tips for Stock Market Traders & Investors

Today I want to scratch the surface about taxes when it comes to trading, investing in a stock market. For those profits that you’re making in the stock market, you’re going to be taxed on those profits. It doesn’t matter if those profits are from dividends, short term or long term profits.

The way that the tax system is written it’s very complicated. If you know some of the angles of where you can reduce those tax bills take advantage of those.

Knowledge is power. The more you know, the better you can set yourself up for the future. You can manage that your tax bill could save you 5%, 10%, 15% in the future from paying those additional fees.

If you compare a regular business, you’re going to be paying different tax brackets. In different situations, you’ll be paying more or less depending on how you structure and run your company.

How Things Works In The Market

It’s all about understanding how much money you’re making. Also, it’s important to know how much money you’re funneling in one area to another area.

For example, donating things to charities allows you to deduct things from your taxes rather than throwing those items away. It’s crucial that you know how the tax systems work. You need to understand how things work within stock trading if you plan to trade stocks.

Here and now I’m sharing with you the surface level stuff. I’m not an accountant and expert when it comes to taxes. I haven’t read the tax manual of the IRS code. These are some insights that I’ve learned over the years. I learn all of it by reading about stocks, learning about my investments and finances through my accountant.

I’ll share with you some wisdom that I’ve seen over the years.

This is what I’ve worked on:

  • active trading
  • basic stock investing
  • dividends
  • option trading

You’ll see some of those critical insights right here in this post.

Learn Few Things About Dividends

The first thing you’ll want to be aware of is a dividend and how they are taxed.

Dividends are taxed at:

  • 0%
  • 15%
  • 20%

This depends on the tax bracket that you fall into. If you fall into the 10%-15% tax bracket, your tax rate on dividends is zero. You must include the dividend income with your other income to determine your tax. Then if you fall into the 25%-35% tax bracket, you’ll be paying a 15% rate on your dividend or 15% tax.

You might fall above those then you’ll be paying the 20% on your dividends. That means if you’re in the 39,6% bracket, you’d be paying a lot more in tax. It’s 5% more if for those dividends.

This is the way dividends are taxed. It’s 15% is basically what most people will be paying. But if you’re in a very high-income bracket, then you’ll be paying that 20 percent on dividends.

Be Aware of Long-Term Capital Gains Tax

The next thing that you want to be aware of is the long-term capital gains tax. It works similar to the dividend basis. There’re brackets, but there is one thing you need to understand about long term capital gain tax.

If you hold a stock for an extended period, you get a tax break a lot less than you would if you kept things for the shorter term.

Quick example:

You hold a trade for 390 days or 450 days. Then you sell it, and you take your profits. Now you’re classified as a long term capital gains tax.

Whereas if you hold it for a shorter period, you’ll be charged at the short term capital gains tax rate.

Short-term Capital Gains Tax – Must Know

The short-term capital gains tax is when you’re making trades. If you’re a day trader, you’re going to be paying short-term capital gains tax.

The thing to know: Short-term capital gains tax is much higher than long-term capital gains tax. It’s going to depend on the bracket that you’re in, and it can depend on the current year.

Those things may change from year to year. You may want to review those rates with your accountant. Pick up the phone and see what they are currently. Because if you’re reading this post at some future date and time, they may have changed.

In either case, short term capital gains tax at this point is charged a lot higher. The reason for that is they look at it as not gambling income, but it’s more active.

If you’re more active in something and you’re churning over money and financials, then you’re going to be paying a higher income. Or a higher tax on that income or profit and loss.

That’s what happens with many people who are a day trader, swing traders. If you’re cranking out trades any time that they’re less than a year you’re going to get charged that short-term capital gains tax rate.

And yes, that’s unfortunate especially if you’re trying to move more into the full-time trading income side. Also, it’s unfortunate if and you’re trying to trade full time. The reason is that you’re going to be charged that short term capital gains tax.

I know it sucks, but that’s just the world that we live in. You can hold some of those trades out for a little bit longer and get that longer-term capital gains tax. That way you can fit into that bracket. If you do so, you can be in the long term capital gains tax.

Maybe you didn’t make a $10,000 profit. Perhaps you only made a $9,000 profit. However, you made up for it by holding on to that stock for just a few more days. That way you can get into the long-term capital gain tax bracket.

Keep in mind when you’re looking at the long term capital gain tax you’re looking at that the rate that you hold the trade.

It’s the amount of time that you’re holding on to the trade.

That could be from:

  • January 1st of 2018 to January 1st of 2019
  • August 2018 to the end of August of 2019

It’s based on your whole time. It’s not based on the calendar year. That’s what it’s based on it. The amount of length of time that you’re holding it for. Because that’s what’s considered a longer-term investment.

You Taxed on Your Net Gains – Focus on This

The way that you are taxed when it comes to your investments in your trading is that your tax based on your net gains. This is your final net gain. If you don’t understand what a net profit is, pay attention to this example.

Quick example:

Let’s say you made $50,000 on multiple trades. You make $50,000 trading in and out of stock. But then you also lost $20,000 on other trades.

$50,000 – $20,000 = $30,000

That means that $30,000 is what you are taxed on. It’s the final difference whatever your profit is. That’s what you’re taxed on. Think of it like the income and expenses balance sheet. It’s not necessarily that exact way which I’ll share with you here in a second why. But it’s the big difference between your total income and your total expenses or your losses.

Your profits – Your losses = That’s what you get taxed on

That’s what it is when it comes to the IRS as far as investing goes. However, here’s a few little differences that go along with this if you’re able to get classified as a professional trader. This is what I was referring to. It’s based on the 429 rule of the 429 trader status which can save you money.

The way that this rule works is a little bit differently. For example, when you have an LLC Corp for regular business, you’re saving through payroll. You can do this by funneling money into an entity, and then you pay yourself a salary. That’s one way that you work up business.

You’re funneling money one way, and then you’re going and paying yourself a wage. You don’t have to pay that Social Security and Medicare and those kinds of things. You save some of that additional taxes that you would have to pay.

429 rule it allows you to break things down as a trader. Now that you have a trader status rather than just a regular investor it shifts the needle for you. Getting this status is difficult. But it allows you to start deducting some additional things.

See what I mean: If you purchase one of my books or products if you’re classified as a professional trader, you can deduct those as an expense.

Usually, you wouldn’t be able to do that because it doesn’t fit along your business. It doesn’t fit along your business of conducting and handling money. You can’t duck those things as far as educational material goes from books, seminars, hotels…

Those things don’t they don’t work because they don’t apply. It’s not ethical, and it’s not legal. That’s not what you should be doing.

When you have trader status you can have things like this:

  • attend a trading seminar
  • buy a course of mine
  • purchase books about trading

And you can deduct it because you’re running a business. That’s what this does. It allows you to classify this as a business. The other thing is that allows you to get away from that additional social security and the Medicare tax that you’ll be paying the extra fees on.

There’s a lot of other perks behind it. They’re more subtle depending on the way that you’re running the business. And depending on the way that you’re trading but those are some of the main significant differences in that trader status.

The main focus is on that you’re saving a considerable percent (14%, 15%) on those additional Social Security taxes that you don’t have to pay. In other words, it’s the rich get richer through these tax breaks.

They make the law so complicated. If you’re able to get through and you’re ready to get classified as a trader you can save a boatload of money.

Quick Look at IRS website

If we visit the IRS website and we go to topic 429, we can look at the sections as:

  • investor section
  • dealer section
  • trader classification section

You can read through this rule and see more details. You can see that for many regular investors who profit it off of dividends or interest, or just appreciation is not going to classify you as an active trader. You need to be making money from day-to-day activity.

Your activity must be substantial. They’re going to judge you this. It’s going to vary from whoever looks at your form at one point or another.

And you must carry on with the activity with continuity and regularity. You have to be probably doing it for quite a bit of time, and they like seeing those histories. Typical holding periods for securities are bought and sold. That’s what they’re going to look at.

Let’s say you’re spending six hours a day trading and then studying and researching then you can maybe also get that as a little bonus. Think about it. You get a small check mark for each one of these things. Then the more check marks that you get, the better off you are. It’s something like a point system.

You can continue reading through this. There’s a lot of additional benefits that go with this beyond just making the deductions for trading education. It comes down to saving also on Social Security and Medicare taxes that have to be paid on those incomes. In that case, you can also set up some special retirement accounts that are more tax friendly as well.

It’s all about knowing the right accountants that are going to do this setup. The first things first are you would have to be classified as a trader here by the IRS.

Sometimes it’s not favorable for you to do this. In certain situations, it may be not as beneficial depending on your situation. It’s important to recognize how you like to trade first and then see if you can get that classification. And if it would benefit you.

One of the things is if you’re looking to deduct books, educational material, seminars, or personal finance coaching you can probably deduct some of that education.

The reason is that you’re learning more about investments. You’re learning more about books, and now you started getting into that gray area. This is being used for your business and not just trading or investing. You’re still attaining the knowledge and information, or you’re going and attending into these trading seminars and events. If that is the case, you can deduct them because you still have a business that’s for your growing business.

Look at it from that standpoint, but get some insight from your accountant depending on your tax situation. I don’t know which position you’re in. I’m not an accountant, and I’m not an expert in these kinds of things. I’m giving you some insights and areas that you can go out and do some more research. The primary goal for me is to provide you with some ideas into directions that you can attack and make things work for you.

Wash Sale Rule Can Hurt You Tax-wise

Keep in mind that the wash sale rule can hurt you as far as taxes go or tax-wise. Let’s say you got into stock at $40 and you went ahead and took a loss at $30. Now you took that $10 a share loss. Then you can deduct that from your taxes.

If you get back into that trade at $32 or $33 less than 30 days from when you close it all of a sudden it negates that loss that you had earlier.

This is the wash sale. It forces people not to take a loss to reduce their taxes right away and to get back into trades. There’s a lot of ways that you can manipulate those things by taking a loss in specific stocks and getting back into them. The IRS didn’t want you to take advantage of those deductions and constantly accumulate loss after loss to reduce those taxes.

This is what some people do:

That way you had no income whatsoever. Some people do this in a funky and weird way from the stories I’ve heard. I don’t think this is legal. What they will do is have multiple brokers, and when they go in on one account/broker, they buy shares. Then another broker they’re taking losses on those shares.

They’re going in the other direction, and they’ll take the loss. I’m not exactly sure how they plan to manipulate the system. However, I know that they’re trying to work their way on these losses and work through that.

There’s a lot of weird and fishy things as you get deeper into understanding the tax rule. I’m not advising you do this because I’m pretty sure it’s illegal. You have to realize that things can get very problematic for you if you’re trying to avoid your taxes.

Talk to your financial accountant/planner about all these things. However, you need to understand that as far as taxes go, you don’t want to sell a stock and take a loss in it and get back in it within 5-10 days. And all of that because of trying to make up those games.

The main reason is you’re going to hurt yourself from being able to deduct that from your losses.

Options Are Taxed The Same As Stocks

If you’re an options trader, options are taxed and the same as stocks. You’re not going to be getting option dividends. But if you’re looking at short-term versus long-term a capital gains tax, it’s the same thing.

You can buy options for three months, six months out. You can sell them three months out, six months out as well. Of course, you can do the same thing for leaps. Longer-term options (300 days, 600 days out) can also work in the same way. They’re taxed in the same manner as the stocks are.

The thing to focus on:

There’s one significant advantage though when it comes to options. That is the 1256 contract rule. It can help index options traders. If you’ve never heard of this rule, pay attention. It allows you to get in and out of these index options very quickly. Not only that. It also will enable you to take only 40% a short-term capital gains tax. And then 60% is long-term capital gains tax.

Take for example a $1,000 profit on the SPX: 

  • 40% of that profit is $400 – is going to be taxed at the short-term capital gains tax
  • 60% of that profit is $600 – is going to be taxed at the long-term capital gains tax

It allows you to save a few percentage points on your taxes. You got almost more than half at the long-term capital gains tax simply by trading index options.

A weird rule that allows you the rich folks or people who have money to slip by. I hate the way that the IRS structures these things. They make it very complicated to where you got to know people. You have to pay people to understand what’s going on and how best to trade to maximize and save money on your tax.

It’s all convoluted. They’re trying to make up rules for different situations. If you’re trading index options like the SPX, the MDX these are all index options.

If you’re trading the SPY, the IWM or the QQQ those are ETFs. Those would not be considered index options. It would be more tax. Depending on the if you are doing options on them again short-term or long-term capital gains tax. You have to be trading the SPX, the RUT or the MDX where they’re indexes to be able to classify it as a 1256 contract rule.

Get more insight about 1256 Contract:

  1. Wikipedia
  2. IRS website
  3. Talk to your accountant

You could also trade the VIX. That’s also an index option that you could trade and take advantage of the 1256 contract rule. There’s a great deal.

You can save:

  • 40% short-term gains
  • 60% long terms capital gains tax

That’s because your training needs future contracts. It makes things a lot better when it comes to these index options. It saves you about probably 10%-12% on your taxes. That is depending on how much trading you do. But it does save you a great deal of money if you understand how this works in the marketplace.

This is the final disclaimer about these taxes and these tax rules and implications. What I wanted to do was share with you some insight into what I’ve learned over the years.

Also, I’ll share with you things I’ve heard, I’ve dealt with and researched. Here’re things I’ve overheard other people doing and trying to manipulate the system. Whoever knows more they’re going to pay fewer taxes. If you know more about them, you’ll pay fewer taxes. Sometimes it’s worth it to pay an accountant $200-$300 for an hour or two of their time. Going in detail about over all these different rules is essential.

Remember this: It’s based on the type of trading that you do. Don’t email me and ask me what’s better for your situation. I don’t know your situation. I don’t know which tax bracket you fall into. I don’t know the other things that are going on in your life. That’s why it’s best to contact an account that can spend a couple of hours with you. He will diagnose your situation.

Then you can get some insight into where it’s best for you to invest in. Or how its best on a tax basis. Don’t look at taxes as far as investing goes. Usually what I say is stop worrying about taxes.

This is how I look at it:

I want to pay more in taxes. Because the more that I pay, the more I’m making. If you have that tax mentality, you’re going to be more profitable in the long run.

However, many people change the way that they trade based on the taxes that they’re going to pay. If you do that you might be trading in ways that you don’t like. Or in ways that don’t fit your trading style, risk style or your personal goals. Don’t focus on the taxes. Instead, understand the fees to where maybe you can adjust your trading a little bit and save on the charges in the long run.

Get some insight from the accountant that understands the tax rules and the tax codes. Then tweak your trading a little bit. But don’t completely change it. Don’t focus on trying to reduce your tax bill or reduce your tax book. That’s going to hurt your trading if you’re not trading correctly.

The Final Word

Some people fit on a day trading basis, and they’re very active and trading 6-8 times a day for six hours at a time. They’re investing a lot in their education, and they could be classified as the 429-trader. They can also get that classification, and it might be beneficial for them.

For other people, if you like trading index options then do it that way. You don’t need the 429 trader status because you’re doing things a little bit differently. You’re saving it over there. Is it worth the extra headache?

Maybe, maybe not. It depends on so many things. Talk to your accountant. Don’t reach out to me and ask me questions about it. I’m not an expert on tax situations. They make those rules and laws just so complicated that you have to be a lawyer to understand.

I’m not a lawyer. I just did my research, my due diligence and shared it with you. That was my whole goal and purpose right here and right now. Sharing with you some knowledge and insight was my goal. That way you can start learning and taking things deeper down one road or another.

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