How to Reduce Your Day Trading Taxes: Tax Tips for Day Traders

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 taxes do day traders have to pay?

The IRS expects you to pay income on all the money you earn, whether it’s from your full-time job, side gig, or day trading. So, 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 you’ll pay a different amount depending on how long you hold the assets.

Short-term vs. long-term capital gains

There are two types of capital gains: short-term and long-term capital gains.

• Short-term capital gains: These gains are those you earn on investments you held for less than a year. Short-term gains are taxed as ordinary income, meaning anywhere from 10% to 37%. The U.S. has marginal tax rates, meaning 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 (though the higher tax rate only applies to the portion of income that falls into that tax bracket).
• Long-term capital gains: These gains are those you earn on investments you held for more than one year. Long-term gains have more favorable tax rates. You’ll pay either 0%, 15%, or 20%, depending on your household income.

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.

Day trading tax election

The IRS has a series of tax laws and regulations that govern investors. However, securities traders who buy and sell securities for a living have a special set of rules that apply to them because it’s considered a business.

The trading tax election has several key benefits, which we’ll talk about in the next few sections. But it also has some strict requirements. To claim this election, you’ll have to meet the following requirements:

• You seek to profit from daily movements in the stock market
• Your income isn’t primarily from dividends, interest, or capital appreciation
• Your trading activity is substantial
• You trade with continuity and regularity

To benefit from the special tax rules for traders, you’ll have to make the mark-to-market election under 457(f) on your tax return. You have to make this election on the tax return for the year before you can start benefiting from these tax rules. So, if you want to start day trading in 2025, then you should make the 457(f) election mark-to-market election on your 2024 tax return.

Once you’ve made this election, you can start using the mark-to-market method of accounting, which comes with some serious tax-saving benefits.

How the market-to-market method helps you save on taxes

There are several different ways that choosing the mark-to-market election can help you save money on your day trading taxes. It’s best to consult with a tax professional or CPA before using any of these strategies.

Deduct more of your losses

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.

Investors can also deduct losses above and beyond their gains. However, this method only allows you to deduct a total of $3,000 in excess losses from your income. For example, if you have $6,000 in losses for the year but only $2,000 in gains, you could deduct $2,000 to offset your gains and another $3,000 on top of that. But you could deduct the final $1,000.

If you qualify as a trader, however, the mark-to-market accounting method 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.

Deduct your 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.

Other tax tips for day traders

In addition to those three main tax-saving tools available to day traders, there are a few other tips that can help reduce your tax liability and help you stay on the good side of the IRS.

Work with a tax professional

If you’re a day trader, you probably want to spend your time and energy doing just that. You likely don’t want to spend your time worrying about tax laws and accounting — and you may not even have the expertise to do so.

If you’re eligible for the trading tax election, it means that day trading is your business. Working with a qualified tax professional can help protect both your business and your personal finances and ensure you’re saving the most money possible while not running afoul of the IRS.

Don’t forget estimated tax payments

The IRS requires people to pay taxes on their income as they earn it. That’s why, when you work for an employer, income taxes are withheld from your paychecks.

If you’re a day trader, there’s no one withholding taxes from your paycheck, but the IRS still wants to get paid. Depending on how much you make day trading, you may need to make estimated tax payments throughout the year to avoid tax penalties when you file your tax return.

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 individual retirement account (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 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.

FAQs

Bottom line

Day trading can be an exciting career or a side hustle. While it’s not right for everyone, the fast-paced environment and quick wins can be enticing to some investors.

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.

Knowing the tax laws and exemptions around day trading can help you stay in the good graces of the IRS while also minimizing the amount you pay in taxes.

If you're thinking about day trading stocks, be sure to also check out the best day trading apps.