Investors can choose between buying and holding stocks for a long time, usually more than a year, until the price rises and sell to make profits or to take advantage of the daily price fluctuations in the stock market to buy low and sell high. The short-term strategy of buying low and selling high over numerous trades is termed daily trading, while the long-term strategy is investing.
While the two techniques appear straightforward, understanding how they affect your taxes could be challenging. Taxes are unavoidable, and every year, you have to pay your tax dues whether you’re trading as a primary occupation or if you’re doing it part-time.
So, how does day trading affect your taxes as a trader? Is there any difference if you opt for invest-and-hold instead of day trading? Read on to find out more.
Implications Of Day Trading On Taxes
Day trading is one strategy that most investors believe can give them more returns and in a short time. If you manage to get your trading spots right by knowing when to buy and when to sell, it’s possible to make more money as a day trader. However, the potential for higher returns means that there are also risks of making big losses.
Before day trading, you need to understand many of its aspects. Knowing that you can make profits is said to be not enough to get you into day trading. One of the crucial things that you need to know is how day trading gains are taxed by the government. Understanding it will help you know what tax group you’ll fall into at the end of the year.
Because day trading is a short-term strategy, it’s usually taxed at the standard income rate taxes. If you’re a day trader, here is how the short-term gain will affect your taxes. Assuming you fall under the 22% tax bracket in your regular job and then you decided to enter day trading. At the end of the year, you profit from your day trading, and therefore, your yearly income is now past the 22% tax bracket. Therefore, you’ll fall into the 24% tax bracket or even higher (up to 37% in some cases).
The gains from day trading will increase the amount of tax you pay. Paying more taxes also means that you take home fewer profits with you from day trading. It’s this reason as to why you should research and understand the taxes you’ll pay before choosing to go with the day trading route, as sometimes it could cause losses if it eats more into your regular income.
However, traders don’t have to pay for all the tax deductions for their gains as some strategies are available that can help them reduce the amount they have to submit to the authorities.
How Day Trading Taxes Compare To Long Term Investment Taxes
Understanding how the majority of day-trading and long-term investments are taxed will help you make a better choice between the two. As discussed, day trading will be taxed at normal income rates as they’re added to your yearly income.
In contrast, when making a long-term investment for over a year, you won’t be taxed on your assets until you sell them. After selling, a certain percentage of your capital gain will be taxed. It’s important to note that the taxation only applies if you sell your investment.
Therefore, day-trading will have more tax implications on your income than a long-term investment. Moreover, long-term investment doesn’t place you in a different tax bracket regardless of the gains you make, as you’re only subjected to a capital gain tax.
How Day Traders Can Reduce Tax
Even though it’s patriotic to pay your taxes as many functions depend on it, as a trader, you shouldn’t miss on any opportunity that’ll potentially help you reduce taxes on your day trading gains. This will help you reduce deductions on your profits and make more money.
Here are some strategies to help day traders reduce tax:
1. Deduct Expenses From The Gain
Because day trading is considered any other business, traders can include the expenses they incurred during the trade. Such expenses include trading equipment, subscription to trading services, transactional costs, and interest for loans used to trades.
When you factor in these expenses, then the capital gain from your trading activities will reduce significantly. In turn, the amount of taxes that you’ll pay will also be lowered.
2.Trade Through Corporations
Another grade way of reducing your taxes is by recording your profits and losses through a C corporation. In a C corporation or C Corp, the business entity is taxed separately from its owners. Therefore, you can work with other day traders so that the gains through the corporation without affecting your tax bracket.
3.Use Mark-To-Market Accounting
A mark-to-market accounting is a technique where day traders can report gains and losses at the end of the tax year so that it appears like everything was sold on the last day of the year. This technique is used to avoid the limit set on the losses used to offset the capital gains. Therefore, you can start a new tax year with zero net gain/losses.
The wash sale rule is a tenet that prohibits traders from buying a similar security 30 days before or after harvesting a loss. Harvesting a loss is where traders sell their securities at a loss for reasons like offsetting gains. However, some exemptions can allow traders to sell at a loss and immediately purchase the security again. Research about the wash-sale exemption and see how beneficial it is, as sometimes, it’s wiser to avoid it.
5.Use Losses To Offset Gains
Other than the mark-to-market option, you can use your losses to offset your capital gain and reduce the taxable income. However, every trader is limited to a certain amount, usually USD $3,000 for individuals or USD $1,500 for couples in every tax year, and any more losses are carried to the following year. Even with the limitation, this will help you to reduce the tax.
Day trading is an excellent way to make money and increase your investments’’ returns. However, it could have some implications on your taxes by placing you in a different tax bracket, meaning you’ll need to pay up more for tax obligations.
Such effects on tax are what you should consider before day trading. Researching will make you make better decisions and ensure that you’re not at a loss with your investment and income. You can use the strategies above to cut down on your tax bills.