4 Tax Strategies to Consider When Trading with Options
It is the time of year that everyone is thinking of a dreaded topic: tax planning.
While it may be too late to change anything for your previous year’s taxes, there are a variety of potential opportunities to consider for your financial situation in the future — especially when it comes to taxes and investing. By investing strategically, you may be able to limit the amount of taxes you owe for the year or potentially be more proactive when a more significant tax bill hits by taking advantage of certain tax rules that apply to options trading.
Keep in mind, you should always talk to your tax accountant or a professional financial planner to discuss the best solutions for your unique tax situation. To help you understand some potential solutions you can consider when it comes to trading options and tax strategies, we’ll take a look at these:
Trading index options
Timing Long-Term Equity Anticipation Securities
Using puts to offset gains
Trading in an IRA
To help make your tax prep season easier, let’s take a look at each of these tactics.
Trading index options
One approach to trading and potentially avoiding significant tax bills is to go for long-term investments, which are taxed at a lower rate than short-term security trading. In general, if a position is held for more than 365 days, it is considered a long-term investment. While options are often traded to generate income and typically held for a shorter amount of time, broad-based index options can provide an advantage.
Index options are considered a Section 1256 contract, which specifies by the Internal Revenue Code that an investment made in a derivatives instrument, such as an index option, if it's held at year-end , is treated as sold at fair market value. Also, index options gains or losses may be considered as a short-term or long-term capital gain.
Index options trading taxes is based on a 60/40 rule. With this rule, 60% of all gains are taxed as a long-term capital gains and 40% are treated as a short-term capital gains and taxed like ordinary income. This tax split applies no matter the length of the holding period.
The 60/40 rule also extends to foreign currency, futures contracts, and some ETFs but index options can potentially allow you to keep more of your gains in the long term due to their favorable tax treatment. However, this could be a disadvantage for long-term investors, as 40% of gains are always taxed at the higher short-term rate.
Timing matters with Long-Term Equity Anticipation Securities
Long-Term Equity Anticipation Securities (LEAPS) are options contracts that have an expiration date greater than one year and typically expire up to three years in the future. With the longer expiration dates, investors can potentially gain exposure to extended price movements through LEAPs.
If an investor sells their LEAPs position and incurs a profit, this will be taxed at the long-term capital gain rate if they held the position for at least 366 days (one year and one day). If the position was held for a shorter time, then they'll be taxed at the short-term capital gains rate.
At the time of this writing for the 2023 tax year, the short-term capital gain rates are the same as ordinary tax rates. This will range from paying 10% short-term capital gains tax rate for the lowest income taxpayers, up to paying 37% of short-term capital gains tax rates by the highest income taxpayers.
Using put options to offset gains
Investors who trade around a dozen or maybe less options contracts every few months may not need a complicated tax plan; they may just need to report trading gains and losses. If you've incurred losses, you can potentially write off up to $3,000 per tax year and with losses higher than that amount, they can be carried forward and reported during future tax years. There is still an annual $3,000 limit.
However, if your large stock positions see a substantial gain, tax season can hit you hard with short-term tax consequences on the profit. Some traders will buy stock puts to hedge their gains in the underlying stocks, but this can work against them if the put position loses value or the stock rallies.
To counter these concerns, some traders will buy in-the-money puts with a strike price higher than the stock price to help mitigate options decay risk. In-the-money puts will have some intrinsic value as an option instead of just time value. These can be effective when the stock already has a long-term holding period.
If the long position has been held long-term and it has appreciated, the put losses are deferred. It is important to remember that this strategy does not provide long-term protection against a decline in the underlying securities. If the long put contract expires worthless, this entire option investment is lost.
Trading options in an IRA
Because individual retirement account (IRA) funds and any gains incurred are only taxed when a distribution is made, it can be beneficial come April 15th.
Investors are only taxed on distributions; some will take advantage of claiming a loss and rebuying the same or similar stock when the price is low while avoiding the wash-sale rule. It is important to ensure that the assets traded in the IRA are not taxable, or this rule will still apply. In addition, not all brokerages will allow options trading within an IRA, and others will limit certain options strategies. It is essential to conduct research before trading in an IRA.
Key Takeaways
When it comes to trading and tax season, there are a number of strategies you can consider to help lower your potential taxes on options. Options can provide some unique advantages and strategic solutions but can come with significant risks as well. However, it is essential to completely research these strategies and see if they may fit your unique trading positions and portfolio. You should also speak with a professional financial advisor or tax accountant to ensure that you are taking the best route for your desired outcomes and receive answers to your tax questions.
Trading options with moomoo
If trading options are a strategy that fits your unique goals, moomoo has the tools you need. With advanced features including real-time data, unusual options activity, and options education and courses. The app offers individual investors a professional-level trading experience — for free! And moomoo does not charge equity options contract or platform fees. It has no monthly maintenance fees or data fees for real-time monitoring. Other fees may apply, check our pricing page for more info at moomoo.com/us/pricing.
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Sources:
https://www.nasdaq.com/articles/understanding-tax-advantages-of-index-options
Tax treatment of index options: Under section 1256 of the Tax Code, profit and loss on transactions in certain exchange-traded options and futures are entitled to be taxed at a rate equal to 60% long-term and 40% short-term capital gain or loss, provided that the market participants involved and the strategy employed satisfy the criteria of the Tax Code. Market participants should consult with their tax advisors to determine how the profit and loss on any particular option or futures strategy will be taxed. Tax laws and regulations change from time to time and may be subject to varying interpretations.
Moomoo Financial and its affiliates do not provide tax advice and any tax-related information provided is general in nature and should not be considered personalized tax advice. Consult a tax professional regarding your specific tax situation.