Day Trading Taxes: What Investors Should Be Aware Of
Day trading isn't just for professionals. It’s becoming more widespread among the general public, thanks to the increasing popularity of same-day platforms that make it easy to buy and sell securities online.
However, there are some serious pitfalls. While your annual profits might look good, day trading taxes can eat into your returns, leaving you poorer than if you’d put your money in a regular market-tracking ETF.
In this post, we explain the tax rules for day traders, how to pay taxes on day trading, and some of the day trading issues you need to be aware of before you buy or sell any securities.
How Day Trading Is Taxed
Day trading involves buying stocks and bonds at low prices and then trying to sell them at high prices or shorting them if the trader expects the price to fall. If the value of the asset rises, the day trader makes a capital gain. For instance, if you buy Apple shares for $400 at the start of a trading day and then sell them for $500 at the end of it, you make a capital gain of $100.
The IRS considers capital gains taxable income, subject to capital gains tax. Therefore, you will always have to pay day trading taxes if you make a profit, regardless of your gross annual income.
Taxes on day trading differ from those on long-term investments. If you hold your money in the markets for less than a year, taxes on stock trades are not as favorable. That’s why day traders, who always buy and sell short-term, must pay more.
How day trading impacts your taxes is quite simple. As mentioned, the day trade tax rate is higher than the one that applies to long-term investments. The IRS taxes short-term capital gains the same way as regular income.
So, profits from day trading simply add to your regular income and are treated the same way. For instance, if your regular income is $40,000 and you make short-term capital gains of $20,000 in a given tax year, your total taxable income is $60,000.
Minimizing Day Trading Taxes
Because taxes on day trading are high, traders regularly take steps to reduce their tax burden. One option is to use retirement accounts due to capital gains in IRAs not being subject to annual taxes. You only incur taxes when you withdraw cash.
If you have a Roth IRA, you may qualify for tax-free withdrawals, regardless of capital gains. That’s because you already paid taxes on income upfront.
You can also manage the release of funds from your IRA account to minimize annual tax take. Specifically, releasing a small amount each year can reduce your total lifetime tax burden.
Another strategy is to offset your gains with losses. If you make money on one trade but lose it on another, you can use this to cut your net capital gain. You can offset up to $3,000 in losses per year if you’re a non-professional trader.
However, you cannot sell an asset at a loss, reduce your net taxable income, and then buy the asset back within 30 days. If you do so, the IRS will void your loss claim under the wash sale rule.
How To File Day Trading Taxes
If you feel confident about preparing your own returns, you can report your day trading transactions on Form 8949. The information you input should match your brokerage provider’s Form 1099-B. You can then summarize your profits and losses on Schedule D.
Here are some additional points you’ll want to bear in mind:
- You may only deduct a maximum of $3,000 in net capital losses from your taxable income each year as a non-professional trader. If you are married and are filing separately, this sum will be $1,500 per year.
- You cannot claim losses over $3,000 as a non-professional. The IRS classifies these as straight losses.
- You must collect receipts proving your losses in case of an IRS investigation.
- You can hold shares in your portfolio you wish to claim losses on for 30 days after selling them under the wash sale rule.
- You should estimate your tax payments throughout the year to avoid penalties and interest from late filing.
Filing day trading taxes can turn out to be a complex task. Therefore, you should consult a professional accountant when preparing all the relevant documents. This way, you’ll be able to avoid penalties or potential IRS investigations into your trading activities.
Trader Tax Status
If you trade 30 hours per week or more, you may qualify for trader tax status (TTS). This designation helps lower your taxes by letting you offset gains with losses above the $3,000 threshold. According to the regulations, you can report your trading income and losses as Schedule C business expenses, allowing you to treat your trading activities like a conventional corporate profit and loss account.
What Investors Should Keep in Mind
Even if you have a firm grasp of how day trading taxes work, that doesn’t necessarily mean you should engage in placing short-term bets on the market. Only a negligible minority of day traders are ever successful. Regrettably, statistics show that the majority of non-professionals lose money.
Also noteworthy, day trading taxes force you to earn much higher returns than regular investors to make the activity worthwhile. To match an annual market return of 10%, your trades need to generate an annualized return of 11.7%. Factoring in all the effort and research required to beat the market, you’ll want a return of 15% or more to make it worth your time.
Example of Day Trading Returns With and Without Taxes
The return you’ll generate from investing $20,000 in the market differs when you take taxes into consideration.
For example, if you were to invest your money in a stock market ETF that generates net returns of 10% per year, your initial investment would be worth $51,874 after 10 years. That means you’ll pay $4,781 on the $31,874 capital gain if you sell your entire portfolio at the end of the period. Your total after-tax gain will amount to $27,093.
Now suppose that you are a day trader and you have to pay taxes on all of your short-term trades. To keep the math simple, we will assume that your tax is 25%, in accord with short-term capital gains tax rules.
These rules state that you have to pay taxes each year, reducing the amount of capital available for investment. Here’s what it looks like in practice:
Trader annual returns, including short-term capital gains taxed at 25%
End-of-year net portfolio value
In this example, the after-tax gain is considerably lower. You began with $20,000 but had to pay taxes on profits each year. Net profits over 10 years were $21,221.52, nearly $5,871.48 lower than conventional investing, even though the rate of return was the same, 10%.
Therefore, to be a successful trader, you need to consistently beat the market for years. According to research, 94% of investing professionals underperform over a 20-year period. If we were to factor in the taxes as well, their performance is likely even more inadequate.
The Bottom Line
Day trading taxes eat significantly into returns. That’s why most investors are better off investing in market-tracking ETFs and allowing their money to grow long-term in tax-advantaged savings accounts. However, there are certain strategies you can resort to for reducing your tax burden on day trading profits, as discussed in our article.
Do You Pay Taxes on Day Trading?
Essentially, day trading taxes work the same way as income tax. If you sell assets you've held for less than a year and make a profit, you add the capital gain to your gross income and tax it in the normal way.
Do Day Traders Pay a Lot in Taxes?
Day traders pay tax in proportion to the profits they make. A day trader making $1 million per year will pay 39.6% tax on capital gains, assuming that all their trades are short-term.
How Do Day Traders Avoid Taxes?
Day traders can avoid taxes by offsetting losses, carrying over losses from previous years, holding funds in tax-advantaged accounts, and filing for trader tax status.
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