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Tax Implications of Trading

Manage your trading taxes more efficiently

If you dread unraveling the tax implications of your trading activities each year, it’s time to take hold of these issues. With a few basics under your belt, you can partner with your tax preparer to manage your trading taxes more proactively, resulting in less aggravation and, hopefully, a lower tax liability.

Know your tax terminology

Cost basis is a term you’ll hear often when discussing taxes for trading and investing. It represents the amount you originally paid for a security plus commissions, and serves as a baseline figure from which gains or losses are determined. If your position’s value has risen above or dropped below your cost basis by the time you close the position, it will generate either a capital gain or capital loss.

Capital gains are generated when you earn a profit from selling a security for more money than you paid for it (or buying a security for less money than received when selling it short). Individual traders and investors pay taxes on capital gains. Generally speaking, if you held the position less than a year (365 days), that would be considered a short-term capital gain, which is taxed at the same rate as ordinary income. Positions held for longer than a year would be considered long-term capital gains and get taxed at a lower rate – usually around 15% but, depending on your income, it could go as low as 5%.

Capital losses are generated if you incur a loss when selling a security for less than you paid for it (or buying a security for more money than received when selling it short). If you’ve experienced capital losses, you should be able to deduct (or “write off”) those losses, up to the amount of capital gains you earned this year. If you experienced more losses than gains this year, you could additionally write off up to $3,000 of losses beyond your offsetting gains. If your remaining capital losses still exceed the additional $3,000 write-off, you could carry those losses forward to the next tax year when you could take off another $3,000 deduction.

Set up your positions in Maxit Tax Manager

Using the Maxit Tax Manager regularly can save you tremendously in the headache department later on. It’s a quick and easy way to monitor the tax implications of your trading strategy as the year progresses, so you can make adjustments as necessary. It can also save you a boatload of paperwork in April.

Sign in to your Ally Invest account and go to Maxit Tax Manager. Your positions held at Ally Invest should be loaded automatically; if you’ve transferred in any of these positions from another brokerage, you’ll need to add the cost basis information. You can specify your accounting method.

The Tax Manager offers four accounting methods: FIFO, LIFO, MinTax and Versus Purchase. It defaults to an accounting method known as FIFO (“first in, first out”). This refers to positions where you’ve added shares at different cost bases over time. The MinTax method lets Maxit automatically decide which accounting method makes the most sense for you in the big picture; it works most effectively when you’ve added your cost bases and outside positions, so that Maxit can “see” your full trading tax picture. The Vs Purchase method, sometimes known as Specific ID, allows you to modify the default method results, tailoring the accounting method for individual transactions.

Maxit will adjust routinely for options exercise and assignment as well as diverse corporate actions like Splits/Reverse Splits, Rights/Warrants, Stock Dividends, Mergers with or without cash, Spin offs, Dividends/Dividends reinvested, and Redemptions/calls. Maxit even fills out your Schedule D and D1 for you automatically at year’s end.

Watch out for wash sales

A wash sale refers to the buying and selling of “substantially the same security” during a 61-day period or less (30 days on each side of the trade). As the name implies, these kinds of transactions are a “wash” – some activity happened, but in the end you wind up with essentially the same position as before that activity.

You can’t claim losses generated by wash sales for tax purposes. Those losses get deferred to a subsequent transaction that’s not considered a wash. That’s why you need to keep a close eye on which transactions meet the wash sale criteria in the eyes of the IRS. If you don’t identify wash sales correctly, you may have a nasty surprise when tallying your gains and losses for your taxes.

Maxit Tax Manager will alert you to wash sales in your transaction ledger and realized gains and losses for each account. This automated accounting should save your tax preparer loads of accounting time in figuring out all the wash sales – and save you some tax-prep fees as a result.

Tax ramifications of establishing your trading as a business

We’ve discussed how individual investors can only claim up to $3,000 in capital losses per year and minimal expenses (if any). Trading businesses can usually write off greater losses, claim broader expenses related to the business, and worry less about wash sale rules.

If you meet the following broad criteria, talk with your tax advisor about whether (and how) you should consider establishing your trading as a business:

  • You seek to profit from daily market movements of securities, not merely from dividends or capital appreciation (this doesn’t necessarily mean you’re literally trading on a daily basis)
  • Your trading is “substantial” – more than 338 trades annually
  • Your trading activity is conducted with continuity and regularity

If you meet those broad criteria, sit down with your tax professional and discuss the specifics in detail before getting started. Declaring yourself a professional trader isn’t necessarily as clear-cut as other forms of self-employment income. A tax professional can help you establish your trading business on surer footing and inform you of the rules that apply to your personal situation.

Feed your retirement accounts

If you already have an Individual Retirement Account (IRA), don’t forget to contribute this year. If you don’t have a retirement account, consider opening one. Ally offers a wide variety of account types; your tax professional can help you figure out which account best suits your retirement investment strategy.

Consult your tax advisor early and often.

This one bears repeating. The world of taxes for traders and investors has quite a few rules that you may find unexpected – even if you’ve been rocking your own 1040 successfully for years now.