Day trading requires a substantial amount of skill and a little bit of luck in order to be profitable. After all of that effort, the last thing you want to do is lose a big portion of your gains to the IRS. Unfortunately, that's exactly what can happen.
Investors generally have to pay taxes on profits they make, but day traders could face even higher tax bills. Fortunately, there are ways to minimize how much the IRS will take from your tax return, letting you keep more money in your pocket.
What is day trading?
Day trading involves buying and selling securities — typically stocks — one or more times within the same day. The goal is to buy and sell the same asset in a short period of time (known as the holding period) in order to benefit from short-term movements in price.
If you can purchase an investment at a low price and sell it for more than you paid over the course of the same day, you could make a profit.
However, day trading can be a risky strategy, even for seasoned investors. There's a lot of speculation involved in determining how prices will move, requiring close monitoring of the news and markets. If you are trading on margin — which means borrowing money to buy securities — your risk could be even higher.
What taxes do day traders have to pay?
When you're investing money, you will typically have to pay taxes on anything you earn from your investments.
The assets you own — albeit for a short time — as a result of day trading are considered capital assets. When you sell capital assets at a profit, you are required to pay taxes on the difference between what you paid (or an adjusted amount) and the amount you sold it for.
The taxes you pay on profits from the sale of capital assets are called capital gains taxes. But there are actually two kinds you need to be aware of.
- Long-term capital gains taxes: Long-term capital gains tax rates tend to be favorable and could be as low as 0% for many people.
- Short-term capital gains taxes: This rate applies to assets taxed as ordinary income. The income you earn from day trading could push you into a higher tax bracket if you make a substantial profit, increasing your tax rate.
To qualify for long-term capital gains tax rates, you must have owned the asset for more than a year. As a day trader, this typically won’t happen since you’re selling assets that you have owned for a far shorter time. As a result, you’ll be taxed at higher short-term capital gains tax rates making it more important to find ways to reduce what you owe to the IRS.
How to avoid taxes on day trading
Here are a few different options to avoid taxes on day trading. It’s best to consult with a tax professional or CPA before using any of these strategies.
Choose the mark-to-market accounting method
Typically, investors are allowed to offset their capital gains with capital losses. In other words, if you make a profit on one trade but take a loss on another, you can reduce your taxable income for taxes by claiming and deducting your losses. However, this method only allows you to deduct a total of $3,000 in excess losses from your income.
If you qualify as a trader, however, you can take advantage of the "mark-to-market" accounting method. This allows you to deduct losses from trading from your income above the $3,000 limit. Furthermore, at the end of the tax year, all of the gains and losses on your trades are essentially reset to $0, letting you start fresh.
You will have to make a Section 475 mark-to-market election by the tax filing deadline for the prior year. You must also qualify as a trader. For tax purposes, the IRS defines a trader as someone who seeks to profit from daily market moves and engages in substantial trading activity with regularity.
Deduct trading expenses
If you are classified as an active trader trying to make money from market movements, you may be able to deduct investment expenses as a trading business expense. This can open up the door to deductions not available to most taxpayers and help lower what you owe in taxes.
These deductions could include things like a home office, the cost of your internet service and computer, office supplies, and subscriptions to trading services. Any interest expenses from margin loans can also typically be deducted.
Take advantage of the wash-sale rule exemption
Traditional investors often seek to reduce their tax liability by harvesting tax losses. Essentially, this means selling losing investments in the year they make gains. This can lower the investment income on which they have to pay taxes.
There's a catch, however. An IRS regulation called the "wash sale rule" prevents you from deducting capital losses if you sell at a loss but buy the same investment within 30 days before or after the sale.
If you’re classified as a trader, however, you can be exempt from this rule if you use the mark-to-market accounting method. This enables the deduction of losses even if you buy the same asset within a short period of time.
Use tax-exempt accounts
There are certain tax-advantaged accounts that allow you to grow your money tax-free and avoid owing capital gains taxes at all. One example is an IRA, which you can contribute to with pre-tax dollars and which is intended as a retirement account.
By deferring taxes on gains you make in an IRA, you’ll be taxed at your ordinary income tax rate when you withdraw money from the account when you retire. People often end up in a lower tax bracket later in life, so this strategy could potentially result in tax savings.
However, there are some big downsides and risks to day trading in an IRA. First, if you day trade too often, you'll be classified as a "pattern day trader" and could be required to keep a minimum of $25,000 in your account.
There are also limits on deductible IRA contributions you can make each year, so you may not be able to deposit enough, and your brokerage may stop you from continuing to day trade.
Another issue is that standard margin accounts aren't available in IRAs. Many day traders rely on margin accounts which allow them to borrow money they can use to make new trades.
Consider looking for a brokerage that offers a "limited margin" account that enables you to make trades before funds have settled. These accounts require you to keep a large balance in most cases, and you can't borrow against your stocks to make new investments. However, you won't have to wait days for funds to settle before making another trade.
If you can get around these issues, day trading in a tax-exempt account could be a good way to reduce taxes. Just be aware that since day-trading is generally considered a risky strategy, you could be putting your retirement security in jeopardy.
How much tax do day traders pay?
The amount of tax a day trader pays depends on many factors, including profit made and tax bracket. Day trading taxes are generally paid using the short-term capital gains rate, which applies to assets owned for less than a year. This rate can range from 10% to 37%.
Do day traders pay more tax than a typical investor?
Day traders sometimes pay more tax than typical investors, who are taxed on profits at the long-term capital gains tax rate if they own assets for over a year. This rate is typically between 0% and 20%.
However, traders may be eligible for more business tax deductions and special rules that reduce taxes, such as the mark-to-market rule mentioned above.
According to a recent survey by robo-advisor and investment company Betterment, 58% of day traders believe their approach will allow them to earn more substantial profits over a short time. When the goal is to earn money, you don't want to lose a lot of it to the IRS.
If you're thinking about day trading stocks, be sure to also check out the best day trading apps.
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