Options, death and taxes. Well, for today, let’s skip death and just talk about options and taxes.
Like virtually any other type of income or gains, option profits are sooner or later taxed. For those wishing to trade options, it is important to know the tax rules for option trading.
First the fine print:
Here we are discussing U.S. federal tax. Other countries’ or states’ taxes may apply too. Our comments are broad outlines for educational purposes only and apply to individual investors, not financial advisors, brokers or dealers. Make sure you have competent personal tax advice for any investment or trading activity you undertake.
Capital Gains Tax
In general, profits made from option trades generate the type of income referred to as Capital Gains. If you buy an option for $250 and later sell it for $1,000, you have a capital gain of $750, less costs of the transaction. These costs include brokerage commissions or other fees directly related to the trade. In this example, those fees might amount to $10. So, the net capital gain is:
|Sale price of option||$1,000|
|Less Purchase price of option||(250)|
|Less commissions and fees||(10)|
|Net capital gain||$740|
The exact same result would be obtained if instead of initiating the trade by buying an option, the trader instead first sold an option short for $1,000 and later bought it back for $250 to close out the short position. This would also be a $740 capital gain.
How and when would this gain be taxed? The answer depends on several things.
Capital Gains Tax on a Roth IRA
In certain cases, capital gains might not be taxed at all. That would be true if the account with the gain were a Roth IRA. In such an account, income and gains are tax-free. The money in the Roth IRA will have originally come from the investor’s contributions, for which the investor received no tax deduction at the time. In exchange for not deducting the Roth IRA contributions from taxable income in the year(s) when the contributions were made, the investor is free from any tax on the principal or income from the Roth IRA account for life, assuming the rules for the Roth are followed. Following the rules means withdrawing money from the Roth IRA in the form of qualified distributions. Qualified distributions are withdrawals from a Roth IRA that is at least five years old, with the account holder more than 59½ years of age; or withdrawals for a first-time home purchase or due to disability or death (I guess we did sneak death in there). No tax, of course, is the best tax treatment of all.
Capital Gains on a Traditional IRA
If not completely free from tax, in some cases the tax is deferred to a later year. That would be the case if the account where the gain was generated was a Traditional IRA, or an employer-sponsored 401(k) in which option trades were allowed. Such 401(k) plans are pretty rare, but some do exist and are called, for example, a brokerage link, brokerage option or self-directed option. In any of these types of accounts, gains and income are not taxed when they occur. Instead, tax is collected in later years when the investor takes money out of the account in the form of retirement distributions. At that time, the full amount of the withdrawals in a year is taxed at the investor’s then-current full ordinary income tax rate. No distinction is made as to whether the money being withdrawn represents the owner’s original principal, or accumulated income and gains. The full amount of the withdrawal is taxed. Be aware that it is quite possible that income tax rates will be higher in future years, so a deferral is not guaranteed to be a good bet, as it once was.
Long-Term Capital Gains Tax
If the account where the option gains were made is not tax-free or tax-deferred, then it may matter how long the option position was held. For example, like gains on stocks, gains on option positions that were held for more than one year may be subject to long-term capital gains treatment. If so, the net long-term capital gains are taxed at special low rates. The rates are currently 0%, 15% or 20%, depending on your other income.
Short-Term Capital Gains Tax
For options positions held less than a year that are not in tax-free or tax-deferred accounts, short-term capital gains tax rates apply – these are the same as your ordinary income tax rate (10% to 37% currently depending on your income).
Taxes on Non-Equity Options
Certain options have a unique tax treatment under IRS Code Section 1256. This is the same section that defines the taxation of gains from trading futures, foreign exchange contracts and interest rate swaps. The options that are covered by Section 1256 are so-called non-equity options.
Options on stocks are equity options and so are options on all exchange-traded funds. These do not qualify for Section 1256. Options on S&P 500 futures, or on the S&P 500 index itself, oddly, are not considered equity options for this purpose, so they do qualify as non-equity options, even though the index on which the options are based is an index of equity prices. Don’t expect it to make sense – it’s a tax law.
The special treatment that applies to section 1256 assets means that 60% of the amount of any gains on such options are taxed at long-term capital gains rates, and 40% of the gains are taxed at short-term capital gains (i.e. ordinary income tax) rates, regardless of how long the position was held.
There, in a nutshell, is how taxes on options work. As with all investments, the goal is to maximize returns, after taxes. Planning and the choice of the right instruments, in the right accounts could significantly change the amount of tax that you pay.