Ask the tax adviser
Security taxes; and the tax status of day traders.
Social Security taxes and 401(k) money
Dear Tax Talk:
People often mention that contributions to a
401(k) are exempt from state and federal income taxes, but are they
exempt from Social Security taxes? Also, do you have to pay Social
Security taxes on money that is withdrawn from a 401(k)?
You make a very good point that escapes mention when discussing
contributions to 401(k) plans.
An employer is required to collect Social Security
taxes on an employee's wages that are contributed to the company's
401(k) plan. For example if you contribute $100 every pay period
to your 401(k) plan, the employer is required to collect $7.65 in
Social Security and Medicare tax from you. The employer does this
by taking the $7.65 from the remainder of your paycheck.
When the money is withdrawn out of the retirement
plan, you do not pay Social Security or Medicare tax.
Tax implications of
declaring yourself a day trader
Dear Tax Talk:
Greetings from California!
Both my wife and I have retired for a number
of years. A few years ago, we started to trade stocks and options.
Last year, we made a few hundred trades. We reported our gains,
losses, capital gains and losses in our joined individual tax returns.
We never used Schedule
C. Neither did we call ourselves traders.
We plan to report our 2000 income from trading
using Schedule C and call ourselves traders. May we do it on April
16, 2001, (August 15, 2001, if extended) when we file our tax returns?
Or have we have missed the deadline to report our intention to the
Internal Revenue Service on or before April 17, 2000, for 2000 tax
returns? Any reference book(s) you may recommend? Is the Schedule
C form and related publication from IRS sufficient for us to do
Thank you for your time and consideration.
Dear Mr. Tseng:
I'm just an investor and recent market conditions are making my
stomach do flips. I imagine day traders have to have stronger stomachs
or better prescribed medicine. If medicine is not providing relief,
maybe recent tax law developments can.
A day trader can elect to be treated as a dealer
in securities. The principal effect of this election is to cause
the trader's losses to be treated as ordinary losses rather than
capital losses subject to the $3,000 loss limitation. Since a trader
is usually in and out of the market by the end of the day, other
effects of the election are not as significant as the lifting of
the loss limitation. For example, the traders' gains will also be
ordinary gains, taxed at the same rate as ordinary income. However,
since a trader's gains are all short-term, this has no tax effect
as short-term gains are taxed at the same rate as ordinary income.
Also the election requires that the trader recognize gain and loss
on any securities held in his "trader" portfolio at the
end of the year. The trader portfolio is distinguished from his
investment portfolio, which tends to be longer-term holdings. Since
a trader is usually out of positions overnight, the effect of recognizing
gain at year-end would be irrelevant.
Another note of interest to the trader is that
net gains are not subject to self-employment tax. The IRS does not
describe how to complete Schedule C or Schedule
SE to characterize the trading activity as exempt from self-employment
tax. I would recommend including on Line 3 of Schedule SE a notation
that the Schedule C profit is "exempt trading activity gain
under section 475(d)".
Overall then, a day trader has little to lose
by making the election to be treated as a dealer and stands to gain
ordinary loss treatment for losses. In other words, you don't lose
on the gain side since:
- All gains should be short-term anyhow and
taxed at the same rate as ordinary income;
- Net gains are not subject to self-employment
- The requirement to recognize gain on overnight
positions held at year-end should be irrelevant to traders.
If you have losses, you gain a tax benefit by
not being subject to the $3,000 capital loss limitation.
Now comes the complicated part, making a timely
election. According to IRS Revenue Procedure 99-17, the election
in order to be effective for 2000 had to be made either with an
original return filed on April 15, 2000 (i.e. your 1999 tax return)
or with a timely filed extension filed by that date. Yes this is
right, you have to make the election for the current year by the
prior year's tax return unextended due date!
You can get around these rules if you start
a new entity to do your day trading. But in your case, it sounds
like this may already be too late for 2000, since only trades after
starting the new entity would be subject to dealer rules. Even if
you don't make the election to be taxed as a dealer, you would still
qualify to deduct your expenses from day trader activities on Schedule
Since these rules are new and have received
scant attention, I suggest you consult a tax professional if you
intend to avail yourself of these tax provisions.
If you want to read more, check out Bankrate.com's
tax tips on day
trading and tax
-- Posted: June 22, 2002