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Tax Talk with George SaenzSocial 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 Also, do you have to pay Social Security taxes on money that is withdrawn from a 401(k)?

Thanks,
Neil

Dear Neil:
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When the money is withdrawn out of the retirement plan, you do not pay Social Security or Medicare tax.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 this?

Thank you for your time and consideration.
James Tseng

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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:

  1. All gains should be short-term anyhow and taxed at the same rate as ordinary income;
  2. Net gains are not subject to self-employment tax, and;
  3. 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 C.

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 record-keeping.

 

-- Posted: June 22, 2002

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