Tax Considerations & Options When Trading
Creating profits when trading stocks, bonds and other securities can be exhilarating, but this can change quickly once tax time approaches. There are several things that every trader should know about the tax rules associated with trading. The type of account used to trade has a major impact on what tax filing, if any, is needed. The amount of time a security is held is another key factor.
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Types of Trading Accounts
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Trading is the term used when an investor wants to be more active with their capital. An investor buys and holds securities, while a trader makes trades more frequently. The problem with active trading is that it creates taxable situations, unless done in the proper account. Any trading of stocks and bonds inside a standard account will need to be reported to the IRS. Trading done inside a qualified retirement account like an IRA, SEP-IRA, Roth IRA and other qualified accounts does not need to be reported.
Taxable Events Associated with Trading
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Taxable events occur for several reasons, each with their own rules. Capital gains and dividends are the two most frequent events that create taxable situations outside a retirement account. Capital gains occur when a trader sells a security at a profit. Sales of stocks and other securities are reported on a 1099-B. Dividends are company payments to shareholders out of profits, and these are reported on a 1099-DIV. Both capital gains and dividends have varying tax consequences, which depend on the holding period and the taxpayer’s tax bracket.
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Capital Gains Tax
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Capital gains are taxed differently depending on the holding period of the security. Shares that are held for longer than a year are considered long-term, and conversely, securities held less than a year are called short-term capital gains. Long-term capital gains are normally taxed at a maximum rate of 15%, which can go down to zero depending on the trader's tax bracket. Short-term capital gains are considered ordinary income and are taxed at the taxpayer’s regular income tax rate. Capital losses can offset gains.
Dividend Tax
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Dividends are reported on a 1099-DIV and are classified as either qualified or non-qualified. Qualified dividends follow the same tax treatment as long-term capital gains. This means the maximum tax rate would be 15%. In order to be considered qualified, the stock that paid the dividend must have been held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is a line in the sand that states which shareholders will receive the dividend. Any buyers of the stock following the ex-dividend date will not get the next dividend paid. The qualified dividend law is only valid through the 2012 tax year, when all dividends will once again be taxed at ordinary income rates. Non-qualified dividends are taxed as ordinary income.
Alternatives that Lower Tax Liability
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There are many ways to keep taxes down when trading, some complicated and others as easy as choosing the right account or holding the stock long enough. Trading inside a retirement account is one way to avoid tax consequences. All trading, as long as capital is not withdrawn from the account, is tax-deferred or tax-free in a qualified retirement account. This means no reporting on gains and losses or on dividends paid inside the account. Tax law can be complicated, so traders should consult a qualified tax accountant about their particular circumstances.
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