Day trading is one of the hottest trends in financial strategies, especially among those who are new to investing and seeking fast ways to turn a profit. The accessibility is alluring, but that doesn’t mean it’s as simple as many think. Here we will answer the question of how does day trading affect your taxes?
Without proper knowledge, research and skills, day trading is just as risky and potentially destructive as a large-scale investment. Before you get started, you should know fully what day trading entails, how you make money doing it and the implications it can have for your taxes.
Yes, earning money through trading does cost you. If you aren’t careful, you could actually wind up owing more than you took home. So, how does day trading affect your taxes?
What is Day Trading?
In a nutshell, day trading is the act of opening and closing a financial position on the stock market in a 24-hour period. If you open in the morning and close a few hours later, that’s a day trade. This can be extremely profitable if you know what you’re doing. It can also result in serious financial losses when your lack of experience turns every position into a major gamble.
Also called active traders, people who day trade develop a technical strategy to increase their profit. It’s not just about throwing money wherever you expect a big return. They capitalize on short-term price changes and count on their return on investments, so they have to be experts at risk management. The keyword is volatility – this is the security of a price.
To make money within a 24-hour period, you have to be able to gauge volatility and its potential for profit. High volatility means a greater risk. People who excel know how to make the most out of these risks and often come out on top.
Still interested? Check out this guide on day trading for beginners to learn how you can get started on your path to success.
How Does Day Trading Affect Your Taxes?
Despite its skyrocketing popularity, active traders are in a controversial business. Long-term gains are taxed lower than short-term gains. The gap between how much you earn and how much you have to pay in taxes can render the entire process a complete loss if you aren’t prepared.
Frequent traders always pay more than those who have long-term pursuits. So, if you’re on the stock market every day, then you’re going to owe money annually to the IRS. Beyond that, you’ll also have to pay the standard short-term capital gains tax rate. The short-term capital gains tax rate can be up to 37% of your earnings.
Depending on how much you invested and willingly lost, this could result in a serious loss of profit that essentially negates your growth or renders your take-home income so small that it wasn’t worth the energy and money you put into it.
Do You Have to Pay Taxes on Day Trading?
This is a common question a lot of newcomers have, and the answer is yes. There is no way to get around paying taxes on capital you earn in the stock market. Investing apps have exploded in popularity throughout 2020. Because people were at home, out of work or lost their jobs, the prospect of earning thousands of dollars and achieving financial independence through their smartphone was wildly appealing.
Unfortunately, many did not anticipate the cost of trying to get rich through quick investments without a solid plan.
If you’ve held an asset for less than a year, you have to pay the IRS. Whether it’s stocks or real estate, you are taxed for any gain, which means your stock earnings are liable. Keep in mind that if your earnings pushed you into a new income bracket, you’ll have to pay more. This is especially true if you’re also playing the stocks on top of a full-time salary or freelancer’s income.
How to Plan Ahead for Your Day Trading Taxes
Depending on how much you earned, you could owe several hundred or several thousand dollars. Some people will find they owe $30,000 or more. Getting lucky in the stock market always comes with a price, which you should forecast before you start investing heavily.
First, make sure that you do your research. This can’t be emphasized enough. Financial investing can be highly lucrative, but it’s also extremely risky and not for the uneducated or under-funded. Avoid paying any day trading groups run by a stock market ‘guru’ who swears you’ll double or quadruple your earnings by paying a membership fee. These organizations are more or less designed to take advantage of inexperienced people who go wide-eyed at the fast earnings only to be slammed with taxes that year.
Also, read up on tax laws and understand how your gains will be perceived by the IRS. Even if you’re a trader full-time, the government doesn’t consider your profit earned income. This means you won’t be charged the self-employed tax that freelancers dread. However you will have to pay investment income and capital gains tax.
For someone with a limited investment history, the tax liability can exceed their profit. This is why planning ahead and investing wisely is so crucial. It doesn’t just help you earn more in the short-term but also ensures you’ll keep your income in the long-run.