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If you're an active stock trader, you need make extra efforts to make sure that you’re not paying more in taxes than you have to. Here are four ways to make sure your investments don’t become a huge tax liability.
If you pay attention to your paperwork, make the right long-term and short-term investments, avoid wash sales, and careful choose the kinds of funds that you're actively trading, you can be confident that your investments won’t become a huge tax liability.
-Manage your paperwork
-Make the right long-term vs. short-term capital gains
-Avoid the Wash Sale Rule
-Choose where to do your active trading
Manage Your Paperwork
When you're an active trader, the only paperwork your brokerage provides is a 1099 showing all of the sales you made over the past year. The problem is that the brokerage may not report your purchases, which means that it's your responsibility to keep track of the dates and dollar amounts of all your purchases. As an absolute minimum, you need to save all your statements and purchase confirmations.
This "shoebox" method of tracking your investments is fine if you buy and sell in whole lots, which means that you buy and sell stock shares in equal amounts.
But investments are harder to track when you don’t deal in even numbers. For example, if you bought 100 shares of Microsoft twelve months ago, bought 50 more shares at a different price two months ago, then sold 70 shares of Microsoft yesterday, it can be hard to track which shares you just sold.
To keep the paperwork straight, it would be easier to sell all 50 shares you bought two months ago, and 20 of the shares you bought a year ago. But doing so could cost you a lot more in taxes because the tax drops from your normal income tax rates (as high as 35 percent in 2003) to 15 percent (or 5 percent if you are in the 15 percent tax bracket) after you've held your shares for more than a year.
For this kind of record-keeping, use a computer. You can set up a spreadsheet that tracks your purchases and subtracts your sales. But it’s probably easier to use a program like Quicken, which automatically keeps track of how much you paid for each of your shares, and lets you decide which shares you want to sell.
Make the Right Long-Term vs. Short-Term Capital Gains
While all stock profits are capital gains, only those stocks that you hold for more than one year qualify for the preferential tax rates known as long-term gains treatment. The higher your tax rate, the more you can save by holding your stocks longer than 12 months. Long-term gains are taxed at 15 percent for anyone in the 25 percent or higher tax bracket; if you're in the 15 percent or lower tax bracket, your gains are taxed at only 5 percent.
You shouldn't let tax considerations alone dictate when you sell a stock, but if you are thinking of taking a big gain on something you've held for close to a year, consider holding off on the sale until you’ve crossed that one-year threshold.
Avoid the Wash Sale Rule
If you frequently trade in and out of stocks you may run up against the Wash Sale rule. Basically, the rule says that if you sell a stock at a loss and then buy the same stock back within 30 days, you don't get to deduct the loss on your taxes.
Example of a Wash Sale
You buy 100 shares of a disk drive manufacturer for $10 a share, or $1,000. After you buy your shares, a report comes out that the company has been shipping toasters instead of disk drives, and the price falls to $2 a share. You sell your shares at a loss of $800. A week later, the company announces that while it does indeed sell toasters, it is going to start selling them over the Internet. The stock price soars to $20 a share, and you buy back in.
Because you’ve purchased the stock within 30 days of selling it, you don’t get to take the loss on that original sale. Instead, the disallowed loss is added to the basis of the new purchase. Your basis in the stock is the $2,000 you spent on the most recent purchase ($20/share x 100 shares), plus the $800 loss on the earlier sale, for a total of $2,800.
What to Do
The best strategy is to avoid buying back stock within 30 days.
If you do happen to make a wash sale, keep track of the disallowed loss. Because it was disallowed as a deduction, the loss is now added to the purchase price, to swell your tax basis in the stock, and that eventually reduces your taxable gain (or increases your deductible loss) when you eventually sell the stock again.
Choose Where to Do Your Active Trading
Your best bet is to restrict your active trading to a tax-free or tax-deferred account like a traditional or Roth IRA. You can actively trade in these accounts and never worry about reporting anything to the IRS.
Fill your taxable accounts with more stable, tax-friendly long-term securities that you don’t plan on selling for a while.
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