You have alternatives when it comes to tax planning. Targeted investing might trim that bill from Uncle Sam, or at least help you time when you’ll pay.
Screen time should be trading time, free of the slog of tax prep. Still, most traders are aware that, come April, thinking ahead could lead to less nail biting and more coin counting. Did you know that in some cases, due to rules on taxation of stock options, the smoothest tax path runs right through options territory? (Of course, your accountant might have the best road map.)
Consider five approaches, mostly using options, that deserve a closer look:
1. Look into Index Options
Long-term investments—including options on the S&P 500 Index (SPX)—are taxed at a lower rate than short-term trades. This tax treatment of options means, in general, if a position is held for more than 365 days, it’s considered a longer-term investment. As of 2018, Section 1256 investments, including stock index options, are subject to a 60/40 rule. This rule says 60% of gains are taxed at longer-term rates, while 40% are taxed at short-term rates. But in this case, it doesn’t matter how long you’ve held the position. That’s because 60% of gains will be taxed at the more favorable longer-term rates. This likewise extends to foreign exchange (currency) and futures contracts. Talk to your tax planner for details on the “1256” list, and note this rule on taxation of options could change.
2. Take the LEAPS
Trading Long-Term Equity Anticipation Securities (LEAPS)—options contracts that expire up to two years and eight months in the future—can offer a tax advantage compared to buying and selling short-term options contracts. Of course, the position’s holding period dictates the tax treatment. If an investor uses LEAPS to diversify a longer-term portfolio, and holds that position for more than 365 days, profits will be treated as a long-term gain and taxed accordingly.
3. Perhaps Puts (to Offest Gains)
If your large stock position shows a substantial gain but you don’t want to pocket the profit because of short-term tax consequences, you might buy stock puts to hedge the gains in the underlying. The downside: if the put position loses value over time, and/or the stock rallies, this trade might work against you. As a remedy, consider buying in-the-money puts with a strike price above the stock price. Ideally, you’ll mitigate some of the option decay (theta) risk. That’s because these options will have some intrinsic value and not all time value. This approach is best for situations where the stock already has a long-term holding period. Losses on the put (usually due to lapse) are deferred as long as the associated long position has appreciated. Keep in mind that this strategy provides only temporary protection from a decline in the price of the corresponding stock. Should the long put position expire worthless, the entire investment in the put position would be lost.
If you’re an individual investor who trades about a dozen or fewer contracts every couple of months, there’s probably little need for a complex tax plan beyond reporting gains or losses on the 1040 Schedule D. You’ll be taxed on your gains. And if you incur losses, you can write off up to $3,000 worth of red ink per tax year. Losses in excess of that amount can be carried forward and reported in future periods, although still within a fresh $3,000 yearly limit.
Of course, consider consulting your tax professional to ensure that certain rules fit your situation.
4. Trade in an IRA
That’s right. Trading in a self-directed retirement account, like an Individual Retirement Account (IRA), can be beneficial at tax time. Investors are only taxed when a distribution is made, so the wash sale in the traditional sense doesn’t apply. Remember that although the wash-sale rule doesn’t apply to retirement accounts, transactions in an IRA can cause a wash sale in a taxable account. In other words, the IRS will look at the holdings in both accounts to determine if the wash-sale rule was violated in the taxable account. Brokerages vary on rules for trading within retirement accounts, so do your homework. And some don’t allow options in IRAs, while others limit option trading to specific strategies.
5. Beware the Curse of the 1099-B
Finally, here’s a tax tip that‘s not exclusive to taxes on options trading, but simply a calculation glitch for traders to avoid. Many traders sometimes pay more than they should because they simply report the wrong cost basis—the amount paid to enter a trade. Although there’s been an IRS rule change, and brokerage firms must also provide 1099-B cost-basis information, you want to make sure the IRS has all the correct information. For instance, if you enter the wrong amount, the IRS could incorrectly tax you on a gross sale, excluding the trade’s cost basis. That might result in a potentially higher tax bill. So be sure to check, and double-check, your cost-basis data.
This article is an update of the original “Five Tax Options for Traders: Derivatives with Tax Benefits,” published on December 24, 2012.
The information presented is for informational and educational purposes only. Content presented is not an investment recommendation or advice and should not be relied upon in making the decision to buy or sell a security or pursue a particular investment strategy.