A Guide to Options Trading and Taxes

Disclaimer: Record Options Investing (ROI) is not a tax preparation expert. The following information is for reference only about options trading and taxes. Consult your tax advisor or CPA for specific guidance pertaining to how your options investments impact your annual tax obligation.

There’s two things that are inevitable in life: death and taxes. According to the United States’ Internal Revenue Service, the average taxpayer spends 13 hours per year preparing their taxes. Most people hear that number and grumble to themselves, thinking about how much they hate dealing with their annual tax obligations. A primary reason new investors are hesitant to start buying and selling positions is a concern over the implications of options trading on taxes.

Fortunately for new options investors, we’ve put together this helpful guide to help you understand how to manage your risk while increasing your assets and potentially decreasing your tax obligations. This blog post is intended to give you a general idea of how to approach options trading and taxes.

Please note: ROI is not a licensed tax preparation company and we do not offer tax counseling of any sort. For questions related to your specific financial situation and tax obligation, please contact a financial advisor, certified accountant, or other licensed tax professional.

How does investing affect your taxes?

This is a primary question new investors ask, because people don’t want to give the government any more money than they have to, and we don’t blame them! Investing can affect your taxes based on a variety of factors, like your short-term vs. long-term capital gains, your income tax bracket, and your existing financial management system. Of course, the most common question on the minds of new investors is what to expect when you sit down to file your tax returns next spring with your accountant or tax advisor. (Reminder: ROI is not a licensed tax advisor. Always consult a tax professional about your financial situation.)

Last year, new investors opened more than 10 million brokerage accounts. With more time at home in front of screens and people eager to find additional methods to generate income or stimulate financial growth, there’s a new population of investors that don't understand the nuances associated with cashing in on capital gains. Those who don’t take the time to educate themselves and find a competent accountant end up handing over a significant portion of their profits to both the state and federal governments.

If you are investing without a comprehensive understanding of Wall Street and finances, you could end up with a significant bill from the IRS next year. Depending on your taxable income and filing status, you may have to write a check to Uncle Sam for up to 20 percent of your long-term capital gains. That rate increases to 37 percent when applied to short-term capital gains. Even if you had a lucrative year of investing, you still don’t want to hand over more than a third of those earnings to the government.

However, wise investors protect their earnings by structuring their finances appropriately. That means setting up and investing assets in tax-deferred savings accounts. (FYI: Check with your tax professional before reallocating any of your funds or making any significant changes to your existing accounts.)

Understanding Capital Gains

We’ve used the phrase capital gains six times in this blog post already (including the reference in this sentence). But what exactly are capital gains? The definition is relatively simple, but it can be applied in a number of situations. In short, capital gains are any profits you generate outside of income earned as an employee. In most cases, capital gains are the result of the sale of an asset, such as physical property (land, building, car, jewelry), legal entities (like a business), or investments such as options, stocks, and bonds.

Most importantly, capital gains are taxed differently than the income you make working at your day job. Taxation of capital gains vary depending on a number of factors, including politics and the current administration. One of the primary distinctions that determines your taxation rate is whether you generated short-term or long-term capital gains. To get an accurate sense of how taxes will impact any capital gains you earn, speak with your financial advisor or professional tax preparer.

Limit Taxes with Tax-Deferred Savings Accounts

The standard cash/brokerage account you can open with any number of companies does not protect you from any capital gains taxes. Every time you make any profit in a traditional cash account, you will have to turn over a portion of those profits to the state and federal revenue services.

No one invests in options, equity, bonds, or any other position hoping to pay more taxes year over year. That’s why smart investors set up tax-deferred accounts, such as IRAs, 401(k)s, and 529 plans. Each account has its subtle differences, which is a very important reason to work with a licensed tax professional to determine the best decisions for you.

Traditional Individual Retirement Account (IRA)

In a traditional IRA, you contribute money before withholding taxes on those assets. As you manage your risk and accumulate additional resources, you pay no state or federal taxes on those earnings. Additionally, you don’t have to disclose to the government how much you made investing your IRA account. Another benefit of the traditional IRA is that you may be eligible to take additional deductions for contributions you make throughout the year.

If you distribute cash from these accounts after you’ve reached the age of 59 ½, you only have to pay the standard income tax on that money. However, you will incur a 10 percent penalty for withdrawing from this account prior to the age of 59 ½. This makes an IRA an excellent choice for people investing with an eye toward their long-term future.

Simplified Employee Pension (SEP) Plan

Designed to meet the needs of small businesses, entrepreneurs, and self-employed individuals, SEP plans and traditional IRAs are extremely similar. The main difference is the considerably higher contribution limits. Otherwise, the same rules about withdrawals and taxes for a traditional IRA apply to the SEP.

Roth IRA

A Roth IRA is another tax-deferred account type intended for people to use as a means of saving for retirement. The contributions you make to a Roth IRA is money that’s already been taxed. Similar to the traditional IRA, you don’t have to pay taxes on your assets as they steadily grow year after year. That said, you’re not allowed to claim any tax deductions for contributions made to your Roth IRA over time.

Also, you will have to pay a 10 percent penalty fee (just like a traditional IRA) for withdrawing from your Roth IRA before the age 59 ½. However, there are exemptions to this early withdrawal penalty such as purchasing your first home, qualified higher education expenses, and the cost of giving birth to or adopting a child.

Unlike the money that was taxed before you deposited it in your Roth IRA, you can distribute assets from that account tax-free. To qualify for tax and penalty-free distributions from your Roth IRA, you need to be at least 59 ½ years old and the account needs to have been open for at least five years.

401(k)

A 401(k) is an employer-sponsored vehicle to assist employees with retirement costs. The rules about how you contribute, manage, and withdraw from a 401(k) are determined by an employer. In most cases, your employer has chosen a company to manage their employees’ 401(k) accounts and you have limited investing opportunities. The taxes on 401(k) accounts depend on the structure of the program established by the employer.

529 Plans

A 529 Plan is intended for education costs. You can’t deduct any contributions you make to a 529 Plan for your child(ren) but the balance in the account grows tax-free. Many states also offer incentives to people who establish 529 Plans. There’s no penalty for withdrawing from this account for expenses such as qualified higher education institutions, private or religious schools, and other educational costs.

Reminder: Record Options Investing is not a licensed accountant or tax expert. For the most up-to-date information about tax-deferred accounts, speak with your financial advisor.

Contribution Limits with Tax-Deferred Accounts

It’s important to speak with a financial professional about contribution limits for any tax-deferred account you’re using for options investing. As if tax laws and regulations weren’t confusing enough, the total amount of annual contributions you can deposit into any of the account types listed above varies wildly. Of course, multiple factors impact the annual contribution limit for your tax-deferred account, including political malarky in Washington DC.

For the purposes of options investing, you want as much money in your tax-deferred account as possible because that gives you more opportunities to manage your risk and increase your wealth. Maxing out your contribution limits to tax-deferred accounts is a financial planning strategy you should discuss with your accountant or other financial advisor. By depositing as much as you can in these accounts, you make your money work harder for you by investing in options.

Tax-Deferred Accounts Protect You from Capital Gain Taxes

Another key benefit of investing in options in a tax-deferred account is avoiding the considerably higher capital gain taxes. Every time you make a profit on a trade within a standard brokerage account, a sizable portion of that total has to go to the government.

But that’s not the case within an IRA or other tax-deferred accounts. When you eventually withdraw funds from these accounts, you’ll be charged your standard income tax rate instead of the much higher capital gains tax rate. (Please note that this does not apply to Roth IRAs because you contribute post-tax money to the account so you can withdraw funds tax-free.)

What is the best investment to avoid taxes?

Investing your assets isn’t just about risk management and further wealth accumulation. It’s also a means for limiting your tax liability. By regularly contributing to a tax-deferred account, you’re significantly decreasing the amount of taxes the government collects from you every year.

Once you’ve established a tax-deferred account, one of the best investments to avoid taxes is following TOTL’s plan for trading options. We’ve devised a system that can deliver up to a 26 percent return on investment annually. Consider this scenario:

Using this calculator, let’s say you start your tax-deferred account with $5,000. You make monthly contributions of $100. The account is set up for your retirement and you’re 30 years old, so the length of time the money would sit in your account is 40 years. Let’s conservatively estimate that you’ll generate a 15 percent return on investment or estimated interest rate (for the purposes of using this calculator), and the account compounds monthly. In 40 years, that $5,000 account that you began can grow to up to over $5 million. You just need the right financial strategy.

There’s no better time than right now to begin cutting down on your annual tax obligation. That begins with contributing to your tax-deferred savings account and learning about options investing with Record Options Investing (ROI). Sign up today for Record Options Investing’s 14-Day Option Investor course.

Don’t forget to schedule an appointment to sit down with your accountant, tax preparation specialist, or financial planner to discuss how to maximize the contributions you make to your tax-deferred accounts. Record Options Investing and all related entities are not licensed to offer tax advice. All the information provided in this blog post is subject to change. For the most up-to-date information about options investing and your tax obligation, speak with an accountant or tax advisor.

I’m using a standard brokerage account. How does that affect options trading and taxes?

There’s plenty of reasons you may choose to do most of your options investing in a standard cash/brokerage account (though we remind you again to consult your accountant, tax professional, or financial planner before making this decision). However, we’ve spent so much time talking about tax-deferred accounts in this blog because that is the best decision for minimizing your tax liability when options trading.

Before you contribute to your brokerage account, those assets are taxed. For example, you decide you want to invest 10 percent of your paycheck every two weeks. You only get to deposit that money into your brokerage account after income taxes have been collected by Uncle Sam.

Once you’ve contributed your post-tax sum to your brokerage account, you’re charged at least a 20 percent capital gains tax every time you exit a trade. For instance, You buy a short call and sell it off a few days before it expires to make a $1,000 profit. Congratulations! Now write a check for $200 to the Internal Revenue Service because you made a profit on a trade that you completed.

You have opted to only invest in options using a standard brokerage account because you wanted to be able to access these funds at any time without limitations on age or purpose. That’s understandable, but keep in mind that you’re essentially taxed twice on the same money before you even get a chance to spend it on travel, a new home, or anything else.

Additionally, the capital gains tax rate fluctuates regularly. At the time of publishing, politicians in Washington DC are busy debating whether or not the capital gains tax rate should increase from 20 percent to 25 percent. That’s why it’s so important for you to create a financial strategy with a licensed planner, accountant, or tax preparer.

When it comes to options trading and taxes, there’s so many nuances to be aware of before investing your money. The government is always eager to collect as many taxes from you as possible but you haven’t worked so hard to earn those assets that you want to turn them over to Uncle Sam. To invest wisely while minimizing your tax liability, speak with an accountant, financial advisor, or licensed tax professional to determine the best strategy for you and your money.

Once you’ve established a tax-deferred account set up for options investing, sign up for Record Options Investing’s innovative 14-Day Option Investor course. Register now.