Taxes are always a major factor for traders and investors. Anyone who wants to invest in stocks or futures contracts should take into consideration the primary differences in how these investments are taxed. This guide is going to discuss the main tax benefits of trading futures over stocks.
How are Stocks Taxed?
The tax system used for stock investments is quite simple; you only pay tax on any profits you make. This is known as a capital gains tax, and the rate you pay depends on which tax bracket you fall into. If you fall into the 10% or 15% tax bracket, for example, you would pay 0%.
Anyone who doesn’t fall into one of these two tax brackets will be required to pay 15%. But if you happen to earn a minimum of $415,050 as an individual, or $466,950 as a couple, you'll be subject to pay 20% capital gains tax.
The Exception to the Rule
There’s one exception to the rule and that’s if you buy a stock and sell it within one year from the original purchase date. This is known as a short-term gain. Anyone making a short-term gain will see the profit categorized into their standard income tax brackets. For the vast majority of people, this is higher than the capital gains rate.
What About Selling At a Loss?
If your losses outweigh your gains, they can be deducted on your tax return and even used to reduce your overall income wages. For example, you can deduct up to $3,000 from your annual wages. If your losses are greater than the annual limit, you can carry the remaining amount forward into the following tax year.
Why Futures Benefit from More Favorable Tax Treatment
Those who trade futures contracts benefit from Section 1256 in the Internal Revenue Code. This states that futures contracts are taxed at a 60/40 split amount of the capital gains rates (short-term 35% OR long-term 15%), regardless of how long the contract was held, unlike stocks. So 40% of your profits will be taxed at 35% (the same as stocks held less than one year), while the remaining 60% of your profits will only be taxed at 15%, saving you a LOT of money!
With the maximum short-term capital gains rates set at 35% and long-term rates at 15% your total tax rate is actually 23%. For short-term investors that is a savings of 12% annually.
Wash Sale Rules
Section 1256 also states that futures contracts are exempt from wash sale rules. This means traders can report all gains and losses even if they haven’t happened yet because all contracts are "marked to market" on the last day of the year.
So What Does This Mean in Practice?
Not accounting for Futures Expiration; Investor "A" bought a $20,000 precious metals contract in February 2015. If on the final day of 2015 that same contract was worth $25,000 Investor "A" has gained a $5,000 capital gain on his tax return for 2015. And this will be taxed at the 60/40 capital gains rate mentioned earlier.
But if Investor "A" sold the contract in January 2016 at $23,000 he/she would have a $2,000 loss (End of Year Value - Current Year Value) based on the 60/40 rule. And since you can carry back losses for up to three years you can actually reduce your tax bill using these tactics. In practice you can save thousands.
Futures might be riskier assets, but they come with massive tax advantages. Including them in your portfolio could give you an edge when tax time comes each year. To get an in depth understanding of tax benefits be sure to contact your accountant sooner than later.