How can traders manage taxes more intelligently?

Great question. If you dread unraveling the tax implications of your trading from the previous tax year, now’s a great time to get a hold of these issues. (In fact, the sooner you tackle these issues, the more headaches you’ll save yourself for the rest of this year – and into the future.)

With just a few basics under your belt, you’ll be ready to partner with your tax accountant early and manage your trading taxes more proactively – for less aggravation and (hopefully) fewer taxes paid later on.

You’ll notice our shout-out to your tax accountant above – here’s a second one. At TradeKing we’re not tax specialists who provide tax advice, nor do we know the specifics of your full tax profile or history. Many of the examples in this article are simplified and may not fully reflect your tax situation (if at all). Plus, these examples apply to the tax code as of 2010. Remember, the tax code is complex and changes every year, so make sure you consult your tax advisor for the latest information that applies to your situation.

Now get ready to learn a few key concepts in taxes for traders, and along the way we’ll point you in the direction of resources to learn more.

#1: Know your tax terminology

Before we dive into this article, it’s important to establish a few basic points.

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 when 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.

Here’s an example of how capital losses could be carried from one year to the next:

Say you experienced losses of $10,000 and $5,000 in gains in trading in 201X. As an individual trader, you could offset $5,000 of your losses against your $5,000 in gains – thereby zeroing out your gains as a tax liability.

Now, you’d still have $5,000 in losses left over. You could deduct $3,000 of those losses in 201X, and carry over the remainder – $2,000 – into the next tax year, 201Y.

Let’s assume in 201Y you experienced $8,000 in gains and $5,000 in losses. You would offset your $5,000 in losses against the $8,000 in gains, leaving you with $3,000 in taxable gains. Here’s where the $2,000 loss from last year kicks in: you could now offset $2,000 against that $3,000, leaving you with only $1,000 in taxable gains for 201Y.

#2: Setup your positions in Maxit Tax Manager

Using TradeKing’s 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.

To get started, login to your TradeKing brokerage account, then head over to Accounts > Maxit Tax Manager. Your positions held at TradeKing 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.

(Do yourself a favor and add this data as soon as you’ve transferred the position. That way, you’ll help Maxit Tax Manager calculate everything more accurately and save yourself the trouble of racking your memory for this information later on.)

Next you’ll need to choose your accounting method; you can do this within Maxit under the Preferences tab. Maxit Tax Manager 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. For example, consider a position you’ve established as follows:

On May 1, you bought 100 shares of XYZ at 50

On June 1, you bought 100 more shares at 52

On July 1, you bought 100 shares at 53

On July 15, you sell 100 shares while XYZ is trading at 54

If you sold 100 shares on July 15 and didn’t specify which lot you were selling, FIFO would assume you were selling the May 1 lot (“first in, first out”). Your taxable gain per share would then be calculated as +4 (54 – 50, the May 1 cost basis).

If you chose another accounting method – LIFO, or “last in, first out” – you’d default to selling the July 1 shares. Your taxable gain per share would be therefore calculated a little differently: 54 – 53, or +1.

Now you might be wondering, “Why not always pick the lowest taxable figure?” Excellent question – the answer has to do with how this single position fits into your overall tax picture for the year. If you have some capital losses already this year, you might be fine with taking a taxable +4 gain, since you can offset your losses against those gains. On the other hand, if you already have a big taxable gain bill, opting for LIFO and its +1 gain might make more sense.

Maxit Tax Manager offers four accounting methods: FIFO, LIFO, MinTax and Versus Purchase. FIFO and LIFO we’ve already explained in brief. 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.

Once your cost-basis info is established in Maxit, and you’ve chosen an accounting method, you’re well on your way to cleaner tax records. It makes sense to check Maxit periodically throughout the year to see what your chosen accounting method’s implications are for that year’s tax situation. If your trading patterns change, you may find your tax situation changing, too. So you might want to change your accounting method for tax optimization. You should also share these interim peeks into your tax picture with your tax professional.

To check your mid-year tax situation, go to Accounts > Maxit Tax Manager and click the Realized G/L tab at top. Here you can see what the tax implications have been for your accounting method to date. Your tax professional may suggest that you change accounting methods mid-year for transactions going forward; you can do this under the Preferences tab.

This initial setup and occasional check-ins are the lion’s share of the work you need to do. Maxit Tax Manager does much of the heavy lifting automatically. It 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. Aren’t you glad you don’t have to worry about all that?

To learn more about Maxit, please check out our FAQs on Taxes and this video demonstration on how to use it.

#3: 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.

Here’s an example of a simple wash sale:

On 12/1/201X you buy 100 shares of ABC for $25.

By 12/11/201X ABC is dropping, so you sell the 100 shares of ABC for $23 – a $2 loss per share.

On 12/27/201X ABC looks like it might stage a comeback, so you buy in again, obtaining 100 shares at $22.

You may initially think you can claim that $2 per share loss from 12/11 on your current taxes – but hold your horses! Unbeknownst to you, this example counts as a wash sale. Instead of claiming that $2 loss in the current tax year, you’d instead tack the loss onto the cost basis of the new position established on 12/27: $22 cost per share of ABC, plus $2 loss per share from the sale on 12/11, resulting in a $24 per share cost basis.

If you sell those 12/27/201X shares of ABC on 2/1/201Y at $26, you’d create a $2 taxable gain – but that gain would apply to 201Y, not 201X.

As you can see in this example, tacking on that $2 to your cost basis could ultimately save you a few tax dollars in 201Y if you’re able to sell at $26 per share. Without it, you’d be liable for a $4 taxable gain, not $2. But you can also readily see how wash sales complicate matters, especially if you don’t know they exist and you fail to account for them.

It gets stickier. Wash sales not only apply to simple buy-sell-buy transactions like the example above, but also to others you may not expect. Transactions of “substantially the same securities” can pair stock and options transactions as wash sales – if you buy, then sell XYZ, then buy a call option on XYZ, for example. The IRS may even consider a transaction a wash if the securities are in related sectors – selling AT&T and then buying Verizon, both telecom companies.

Confused? Don’t be. TradeKing’s 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.

To stay current on IRS wash sale rules, keep this link handy:

#4: Tax ramifications of establishing your trading as a business

In #1 of this article, we 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.

#5: Feed your retirement accounts

If you already have an Individual Retirement Account (IRA), don’t forget to contribute this year. If you have taxable income, you can contribute up to $5,000 in 2010 and up to $6,000 if you’re over 50 years old. The IRS’ website can tell you more. You may be able to claim these contributions as a tax deduction to your current income – plus harness the benefits of tax-deferred compounding over the years. (Your tax advisor can give you the full scoop.)

If you don’t already have a retirement account, talk to your tax guy or gal about setting one up. TradeKing offers a wide variety of retirement account types, and your tax professional can help you figure out which type of account best suits your retirement investment strategy.

#6: Consult your tax guy or gal — 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.

We aren’t tax specialists at TradeKing, and we don’t provide personalized tax advice – but there are plenty of qualified folks out there who do. Invest a few bucks in hiring a tax professional, and take advantage of his or her counsel. A little interim consultation can go a long way towards managing your taxes effectively come April 15.