How to coordinate trading strategies and tax strategies
A lot of investors and traders, unfortunately, don't have a complete understanding of capital gains taxes and how these taxes can impact profit margins. To a large degree, capital gains tax is a topic that generates a lot of confusion, and most people prefer to avoid thinking about taxes altogether. The simple mention of capital gains taxes related to long-term investments can cause traders to completely disregard any long-term objectives and focus only on short-term gains.
We checked in with the tax experts... what problems do your clients with trading portfolios bring to you, and how do you recommend resolving these issues in the client's best interest?
What kind of short-term impact can capital gains have on my taxes?
According to Nick Coleman, CFP, the common mistakes he sees around capital gains is that retail investors often do not consider the effect short term capital gains have on taxes. Short term capital gains are taxed at the filer's income level, rather than the long term capital gains tax that is set at a much lower 15% or 20%, depending on your income. In order to have proceeds qualify for long term treatment, they must be held for one year.
When submitting your taxes, you will have to split your capital gains into short-term and long-term capital gains, to be taxed at different rates mentioned above. It is important for investors to also know that, if they had a net capital loss in 2021, they can only deduct up to $3,000 from their income in a given year. If the investor has a loss larger than $3,000 the remaining will "carry forward" to be used for next year's taxes.
Coleman notes that traders can typically use a tax software if they have simple tax situations, like dealing with capital gains tax. An investor should consult with a tax planning expert, such as a CPA or CFP if they are taking money out of individual retirement accounts (IRA), donating stocks, finding capital gains reductions, have a more complicated investment strategy, or many different tax situations.
Coleman says that trading in retirement accounts such as IRA's, 401(k)'s, or Roth IRA's do not cause any capital gain, no matter how many proceeds. He suggests using a retirement account if someone is regularly trading or capital gains -- especially short-term capital gains -- is an issue.
Another piece of useful information from Mr. Coleman: A person can offset other capital gains by selling a large capital loss to reduce taxes paid. This is known as tax-loss harvesting.
What should I know about using a Roth IRA and its impact on my taxes?
Kunal Sawhney, CEO of Kalkine Group, can shed some light on Roth IRAs and trading. According to Sawhney, not all retail investors know that products like a Roth IRA can help mitigate the tax burden. Almost every taxpayer knows that stock investments attract capital gain taxes, but there is a simple and legitimate way to prevent this.
A Roth IRA allows tax-free withdrawals. This option can be used to make investments that can otherwise attract heavy levies. Today, many retail investors are warming up to stocks, thanks to the proliferation of online discount brokerages. These investors have parked money in all types of assets -- stocks with growth potential like the clean energy sector and dividend-paying blue-chips. It is better to trade in a Roth IRA.
The other piece advice of advice Mr. Sawhney had for retail investors is to hold a stock for long instead of booking a profit when a stock rises sharply. Long-term capital gains tax is lower than short-term gains tax accrued from buying and selling of shares.
If I'm married, should I file taxes jointly or separately if there is a trading account involved?
The married filing separately status brings many complications and calculations, and for us, understanding why the question is being posed is an important first step, according to
Gail Rosen, CPA. Rosen goes on to say that, i
n most cases, the combined tax liability for married separately can be significantly higher than married filing jointly. We estimate the tax liability for each party so that the spouse we are representing has all the information necessary to make an informed decision.
This decision takes into account many nuances of tax law and practicality. There are complications involved in deciding which spouse is entitled to claim the income, expenses, taxes paid and/or dependents. We outline these matters so our client understands the issues they may encounter. Overall, Rosen believes it is important to consult a tax professional when it comes to deciding how to file taxes with your spouse.
What should I do if I am stuck with a low basis in a highly concentrated position?
Here are two ideas from Andrew Rosen, President of Diversified LLC, a comprehensive financial planning and investment firm. One, Rosen suggests that you can sell some positions in the current year when you know what the tax rates are. In doing so, it is easier to control the capital gains situation.
Rosen's second idea is one of his favorite strategies is utilizing a Donor Advised Fund (DAF). This allows one the ability to simply gift these low basis holdings to a DAF, receive the charitable deduction on the full amount, then diversify and use it as a charitable fund for the future. Anything held short term is taxed at your regular tax bracket which could be as high as 37%. The idea of gifting something into a DAF means that you would avoid the capital gains tax, and get a charitable deduction on the full amount of that investment, which is a good option for a low basis stock.
The expert you’d want to work with would be a tax professional and a financial planner, according to Mr. Rosen. For a tax professional, look for a CPA (Certified Public Accountant) and for a CFP (Certified Financial Planner). It’s best when they can work in tandem to provide holistic solutions and so both sides of your financial life are working hand-in-hand with the other, so your tax strategies are informing your financial plan and vice versa.