Investing in stocks can create income or losses in several ways, including interest, dividends and capital gains and losses. The deductions that investors are allowed to take on their income tax return vary depending on the nature of the underlying investments and the nature of the investment portfolio.
Day trading occurs when an investor follows the real time prices of stocks and trades on extremely short-term fluctuations in share price. To be considered a day trader, the trading must be continuous and voluminous. For example, if you are buying and selling stocks on average five times a day for the entire year, you will likely be considered a day trader by the IRS. Net gains and losses on day trading count as regular business income or loss for the year. This distinction is important because net trading losses can be used against other sources on income on the tax return. However, if there are net gains, they will be taxed as business income, which is often taxed at a higher rate and triggers self-employment tax.
Stock Trading in a Registered Plan
Gains, losses and investment expenses in tax-deferred or tax-exempt plans, such as 401k plans, traditional IRAs or Roth IRAs, have no tax impact when incurred. In Roth IRA plans, they will never be taxed or tax-deductible as the income in those plans are exempt from tax. In 401k plans and traditional IRAs, they will only be taxed on withdrawals from the plan in retirement. Capital losses in a tax-advantaged plan cannot be used to offset other sources of income.
Tax Loss Harvesting
For those investors who buy and sell stocks but are not day traders, managing capital gains and losses is an important tax reduction tool. Capital gains in excess of capital losses are taxed in the year the gain occurs. Many investors sell their poor-performing investments in years where they would otherwise have high capital gains. They generate losses to offset some of the gains. This is called tax loss harvesting or crystallizing losses. If an investor has more losses than gains in the year, he may use $1,500 of those losses against his other sources of income that year. The rest can be carried forward to future years indefinitely to use against future capital gains.
Deduction of Investment Expenses
Buying and selling stocks can result in many investment expenses, most of which are considered deductible by the IRS. They fall into the category of miscellaneous itemized deductions, which means that they must, in total, exceed 2 percent of the taxpayer's adjusted gross income in order to begin deducting. These expenses include safety deposit boxes, fees paid for investment advice, subscriptions to investment-related research, investment tracking software and accounting fees related to the investment portfolio or its taxation. The interest expense on borrowing money to invest can be deducted to the extent that there is still investment income left over after the other investment expenses have been deducted, but it cannot create an investment loss. Any excess of investment interest can be carried forward to future years to use against investment income indefinitely.
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