5 Approaches for Taxes on Options Trading
When it comes to tax planning, you have options. Targeted investing may help you reduce Uncle Sam’s cost, or at the very least help, you plan when you’ll pay.
Free of the drudgery of tax preparation, screen time should be spent trading. Nonetheless, most traders are aware that planning may result in less nail gnawing and more coin-counting come April. Did you realize that, in some situations, the smoothest tax path passes right into options territory due to regulations on stock options taxation? (Of course, your accountant may have the most up-to-date information.)
Consider five approaches, mostly using options, that deserve a closer look:
Look into Index Options
Short-term trades are taxed at a higher rate than long-term investments, such as options on the S& P 500 Index (SPX). Because of the way options are taxed, if you hold a position for more than 365 days, it’s considered a longer-term investment. Section 1256 investments, such as stock index options, are now subject to a 60/40 rule as of 2018. According to this regulation, 60% of gains are taxed at long-term rates, while 40% are taxed at short-term rates. However, in this scenario, it makes no difference how long you’ve been in the position. Because 60% of gains will be taxed at the lower long-term rates, this is the case. This also applies to futures contracts and foreign exchange (currency). Consult your tax advisor for more information on the “1256” list, and keep in mind that the taxation of options is subject to change.
Take the LEAPS
When opposed to buying and selling short-term options contracts, trading Long-Term Equity Anticipation Securities (LEAPS)—options contracts that expire up to two years and eight months in the future—can provide a tax benefit. The tax treatment is, of course, determined by the holding time of the position. If an investor employs LEAPS to diversify a longer-term portfolio and maintains the position for more than 365 days, the earnings are taxed as a long-term gain.
Perhaps Puts (to Offest Gains)
If you have a significant stock position and don’t want to pocket the profit due to short-term tax implications, you can buy stock puts to hedge the gains in the underlying. The negative is that this trade may work against you if the put position loses value over time and/or the stock rallies. Consider purchasing in-the-money options with a strike price above the stock price as a cure. Ideally, you’ll be able to reduce some of the danger of options decay (theta). This is due to the fact that these alternatives will have some intrinsic worth in addition to their time value. This method works well in circumstances where the stock has already been held for a long time. Losses on the put (usually due to lapse) are deferred as long as the associated long position has been appreciated. Keep in mind that this method only protects you from a brief drop in the price of the underlying asset. The entire investment in the put position would be lost if the long put position expires worthless.
If you’re an individual investor who trades a dozen or fewer contracts every couple of months, you generally don’t need anything more complicated than a 1040 Schedule D to report your gains and losses. Your profits will be taxed. You can also deduct up to $3,000 in losses every tax year if you experience them. Losses in excess of that amount can be carried forward and reported in subsequent years, but only up to a new yearly limit of $3,000 each year.
Naturally, you should consult a tax specialist to check those particular restrictions apply to your situation.
Trade-in an IRA
That’s correct. At tax time, trading in a self-directed retirement plan, such as an individual retirement account (IRA), might be beneficial. The wash sale in the traditional sense does not apply because investors are only taxed when a distribution is made. Although the wash-sale rule does not apply to retirement funds, transactions in an IRA can result in a taxable account being washed out. To put it another way, the IRS will examine both accounts’ assets to see if the wash-sale regulation was broken in the taxable account. Do your study because brokerages have different restrictions for trading within retirement funds. Some states prohibit the use of options in IRAs, while others limit the use of options to specified techniques.
Finally, here’s a piece of tax advice that isn’t specific to taxes on options trading, but rather a calculation error that traders should be aware of. Many traders overpay because they report the inaccurate cost basis—the amount paid to enter a trade—and hence pay more than they should. Even though the IRS has changed its rules and brokerage firms are now required to give 1099-B cost-basis information, you should double-check that the IRS has all of the correct information. For example, if you submit the wrong amount, the IRS may mistakenly tax you on a gross sale that does not include the cost basis of the deal. This may result in a greater tax bill. So double-check and triple-check your cost-basis information.