There are endless ways to invest, with vehicles and opportunities to suit different needs, time horizons, and risk tolerances. As you explore the various options available, it’s wise to consider the tax consequences of your investments.
Frequent, active trading with a goal of chasing profits can bolster your income nicely—but taxes can eat into your gains. Passively traded index funds, like mutual funds or exchange-traded funds (EFTs), are generally more tax-efficient and cost-effective than actively investing or picking a growth-oriented fund that does that for you.
Index funds hold a portfolio that aims to match the performance of a given market index or benchmark. This means that they buy and sell less than an actively managed fund. More frequent sales tend to result in capital gains, including short-term gains taxed at higher regular income tax rates. (Active trading means higher management fees and expense ratios, too.)
Actively traded mutual funds must distribute earnings from interest, dividends, and capital gains annually to all shareholders. While you’ll benefit from the gains, you’ll also pay the taxes even if you individually don’t opt to sell.
Matching an index, rather than actively trading, can help avoid mistimed sales that incur higher taxes. If you’re trading actively and hold assets for less than a year, the short-term gains are taxed at regular income rates, rather than the capital gains rate of 0, 15 or 20 percent. And if you buy mutual fund shares via a taxable account just before the distribution date, you’ll owe taxes on the full year’s gain, even if you’ve only owned the asset for a few days or weeks.
Trading actively also risks running afoul of the “wash-sale rule.” Under this rule, if you sell an asset at a loss, you can’t deduct the loss if you buy the same or a “substantially identical” asset within 30 days before or after the sale date.
If you’re trading actively as an investor—but not so much that you qualify as a trader under the rather vague IRS rules—you’ll face formidable paperwork to stay on the right side of the IRS. You will have to track and report your gains and losses carefully, and you won’t be able to take advantage of the deductions and breaks available to traders.
For assistance with determining an investment strategy that minimizes your tax burden, contact us.
–Toni L. Shears
How to Invest Tax-Efficiently, Fidelity Viewpoints, Jan. 31, 2020, https://www.fidelity.com/viewpoints/investing-ideas/tax-strategy.
Roger Wolner, 4 Strategies to Reduce Your Taxes From Day Trading, Magnify Money, Jan. 3, 2019, https://www.magnifymoney.com/blog/investing/day-trading-taxes/
Mary Hall, Benefits for Benefits for Active Traders Who Incorporate, Investopedia, updated Aug. 3, 2020, https://www.investopedia.com/articles/trading/09/incorporate-active-trading.asp.
Zaw Thiha Tun, Investopedia: Tax Treatment of Put and Call Options, Investopedia, Updated March 31, 2020, https://www.investopedia.com/articles/active-trading/053115/tax-treatment-call-put-options.asp
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