Before getting into day trading, it’s crucial to understand how taxes affect your returns. With that knowledge, you can estimate your after-tax returns and avoid nasty surprises.
How Are Day Trading Profits Taxed?
The IRS treats most investments like stocks and bonds as capital assets. When you sell an investment for more than you originally paid, you have a capital gain, and that gain typically results in a capital gains tax. To calculate your gains or losses, compare the purchase amount to the sales proceeds. For example, if you buy shares of stock for $50 and sell at $60, you have a capital gain of $10 per share. But if you sell at $30, you have a capital loss of $20 per share.
Short-Term vs. Long-Term Capital Gains
Your holding period may affect how any profits are taxed. If you hold assets for more than one year, you typically qualify for favorable (lower) long-term capital gains tax rates. But if you sell before then, which is common for day traders, you have short-term gains and losses. Short-term capital gains rates are generally taxed at the same rate as ordinary income. In other words, any profits would effectively add to your annual income and be taxed at the same rates. Tax rates rise as your income increases, so those with high incomes (or substantial gains) may pay taxes at relatively high rates.
How To File Taxes as a Day Trader
If you’re confident about preparing your own returns, report your transactions on Form 8949. The information on that form should match the information from your brokerage provider’s Form 1099-B. Then, summarize any gains and losses on Schedule D.
Estimated Taxes
If you have gains from day trading activity, you may need to make estimated tax payments throughout the year to avoid tax penalties and interest charges. It may be wise to set funds aside as soon as you realize gains, so you’re not tempted to spend the money elsewhere.
How To Minimize Day Trading Taxes
If you’re fortunate enough to grow your account while investing, it may be necessary to pay a portion of your earnings to the IRS. But there are several ways to manage your tax liability.
Retirement Accounts
Gains and losses in retirement accounts like IRAs are typically not subject to taxes each year. Instead, you may owe taxes only when you take withdrawals from those accounts. Better yet, with a Roth IRA, you could qualify for tax-free withdrawals. However, day trading with your life savings is risky, so be wary of taking excessive risks just to avoid taxes. However, you don’t necessarily need to take all of that income in a single year. As a result, it may be possible to manage your income so that you pay taxes at an acceptable rate.
Offsetting Gains and Losses
The goal of investing is to grow your assets, so taking losses is not an ideal strategy. But any capital losses you experience can offset capital gains. As a result, if you need to take a loss, it can help lower the amount you owe in taxes. However, day traders should be aware of the wash sales rule while trying to harvest losses for tax purposes.
Carryover Losses
If you have losses that exceed your gains for the year, you can potentially use those losses to reduce your tax bill. The IRS allows you to deduct up to $3,000 of capital losses each year ($1,500 if married filing jointly), and you can carry forward losses bigger than that for use in future years.
Tips for Day Traders During Tax Season
Know What Reports Are Available
Find out what reports are available from your trading platform, and provide that information to your tax preparer as soon as possible. Brokerage firms often provide Form 1099-B, which details sales during the year and may also include your cost basis. Monthly and quarterly statements might also tell you about realized gains and losses, helping you understand your potential liability throughout the year.
Track Expenses
Fees, commissions, and other costs you pay when buying can increase your cost basis. Trading frequently can add up expenses even in a low commission environment. With a higher cost basis, your taxable gain is smaller (resulting in a smaller tax liability), so it’s critical to keep track of all trading costs.
Complications With Crypto
If you trade cryptocurrency, prepare yourself for the possibility of additional legwork at tax time. Virtual currencies are relatively new trading vehicles, so tax preparers and other service providers may not have robust systems and extensive expertise to help you. Some trading platforms track your purchases and sales, and can provide detailed activity reports—but it’s critical to check so you’re not scrambling to prepare your taxes. If you mine virtual currency or acquire it in other ways (besides purchasing it on a trading platform), determining your cost basis may be complicated.
