posted on June 18th 2018 in Fort Worth CFP Team Posts with 0 Comments /

Options are a poorly understood asset class to most investors, but have many uses for astute planners. No, we aren’t talking about the type of options your company might grant you, but publicly traded options. For example, adding an options enhancement component to your overall investment strategy may be a great way to enhance how much income your portfolio produces. But what are the tax implications of more income?

Assuming we are talking about a taxable account, it depends on what type of options being traded: options on individual stocks, or index options (think S&P 500, Russell 2000, Nasdaq 100, etc). We can and do trade both types, depending on the situation. Though there are exceptions, most individual stock options we trade will be taxed 100% at your short-term tax rate — as ordinary income.

One benefit index options have over individual stock options is the IRS treats them as “Section 1256 Contracts,” named for the section of the IRS Code that describes how investments like some options must be reported and taxed. Regardless of how long you own them, gains/losses on Section 1256 contracts are treated as being 60% long-term gains and 40% short term. A simple way to remember that is this: you get a tax advantage on 60% of your gains since the long-term capital gains rates are less than the ordinary income rates for all income levels.

If, for example, you are a married filing jointly and making $400,000/year in 2018, you fall into the 15% bracket for long-term capital gains (couples making $77,201 – $479,00), but the 35% bracket for ordinary income/short-term taxable gains. Now, if you made $50,000 from stock options trading during the year, you’d be taxed at 35% on all gains, meaning you’d keep ~$32,500 after taxes. (Note, all examples are overly simplified for illustrative purposes: they do not take into account your full tax situation and should not be relied upon or considered advice of any kind.) That’s well worth the trouble since you are still much better off than if you wouldn’t have done options for income at all, but it’s still not as good as you could do if you were trading index options instead. With index options, you’d pay 35% on 40% of the gains and 15% on 60% of the gains — an effective tax rate of about 23%. You’d keep $38,500, or about $6,000 more than you would’ve kept doing only stock options.

The benefits don’t just extend to high-income clients. Retired clients who have substantial savings but are living on a more modest fixed income can benefit from the favorable tax treatment. For example, if your joint income is $77,200 in 2018, your ordinary income is taxed at 12% while your long-term gains are taxed at 0%. That means you’d keep ~$47,600 out of the $50,000 made on options trading during the year.

Of course, if you require options to be traded on individual stocks, you should expect predominantly short-term gains. Keep in mind, however, that unless you need the options to be traded on the stocks you already own, we aren’t limited to trading options on individual equities. For example, you could own individual stocks in your taxable account, but we could still trade index options for you. When you speak to us, you’ll tell us more about your situation and we’ll explain what’s right for you.

Does trading options always mean more taxes? Unless you are in a low income tax bracket and don’t have enough capital gains to push you up the the next gains bracket, the answer to that question is usually yes. There is no way to eliminate taxes short of doing them in a tax-advantaged account such as an IRA, or if you happen to have losses to count against them. Whether they are taxed as long-term gains or short term, if we are making you money in options, you will pay more taxes. Generating more taxes doesn’t mean we’ve been inefficient; it means we were successful! We’ll try to keep your taxes as low as possible, but not at the expense of making more money. Even if we are being as tax-efficient as we can be, the more success we experience, the more taxes you’ll pay. More taxes are simply the inevitable side-effect of making more money. You should expect this and proactively let us know if you’d like us to try to harvest some losses to offset the gains we’ve created from a tax perspective. The more active you are in keeping your financial planning up-to-date, the more we can help guide you on what to expect and talk to you about any maneuvers we can make to help. Just don’t wait until the holidays to try to scramble to a decision!

We acknowledge nobody likes paying taxes, but we still have to look at it like a business rather than an emotional aversion to taxes. If you collected $10,000 more in income this year because of options trading and that caused your tax bill to be $2,300 higher, you are still $7,700 better off!

Do index options have other tax advantages? Yes.

  1. Your broker will report the “aggregate profit or loss on contracts” using a simple one-page 1099-B. That means the form does not report every single trade, but instead the aggregate of all trades made in each individual index product. For example, if we traded five times in the S&P 500 contract, all those trades would be aggregated to show you what we gained or lost in trading that contract during the course of the entire year. Simple, right? You’ll then report your gains on IRS Form 6781 Part 1, which breaks down the gains into the aforementioned 60/40 split. Lastly, those amounts move to the Schedule D capital gains and losses.
  2. Index options have an unusual and less-used feature called a loss carryback election. This allows you to carry back losses up to 3 years to offset any gain you made in Section 1256 contracts in those years. Any unused losses can then be carried forward.

In conclusion, understand this is not a full treatment of the topic and is not intended to be tax advice.  

about the author: Joshua I. Wilson CMT

Josh-Wilson CMTJoshua I. Wilson, CMT®, AIF® is a partner and wealth manager who has managed over $2B for TD Ameritrade. Joshua led the national training and development program for all of TDA’s new advisors and managers, won a national coaching award. Joshua gave his graduation speech at Brown University. Joshua is a Chartered Market Technician® (CMT®) and a Accredited Investment Fiduciary® (AIF®).

Learn more and/or Contact Joshua

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