The first thing to note when diving into the world of taxes for traders is that profits made aren’t considered earned income but rather capital gains.
Two ways trading taxes are classified in the United States
In the United States, Traders have two options for reporting and paying taxes on trading. You can file earnings under section 988 or section 1256 with the Internal Revenue Service.
Section 988 is a tax regulation governing capital gains or losses on investments held in foreing currency.
These capital gasins will be taxes as ordinary income.
It’s important to understand that the US tax code make a distinction between the short term and long term capital gains. The tax on long term capital gains can range from 0% to 20%, depending on the amount of annual earnings brought in by the trader.
With section 988, the actual amount that Forex Traders will pay for their profits does depend on the tax bracket they fall into.
If the trader files their earnings under this section, the effective tax rate can be anywhere from 0% to 37%.
Below is an example of the different tax brackets in the US:
A major benefit for traders filing their trading earnings under section 988 is the fact that they can use the total amount of their net losses to reduce their taxable income
For an example, let’s say that a trader had a $20,000 live account. The trader opened a long position on GBP/JPY and the market moved against his position. By the time he closed he was down $3,000. This trader can now file this loss on their trading returns under section 988 and reduce their taxable income by that $3,000.
So for an example let’s say that the trader made altogether $125,000 that year. The traders taxable income would now be $122,000. Since they’d be in the 22% tax bracket, the trader would have saved $660 in owed taxes.
What makes a Section 1256 contract unique is that each position held by a taxpayer at the end of the tax year is treated as if it was sold for its fair market value, and gains or losses are treated as either short-term or long-term capital gains.
For example, Let’s say a trader went long on EUR/USD on May 5, 2020. At the end of the tax year, Dec. 31, he still has the trade open and it is valued at $29,000 in profit. His mark-to-market profit is $29,000 and he reports this on Form 6781, treated as 60% long-term and 40% short-term capital gain. On Jan. 30, 2021, he closed his long position for $26,000. Since he has already recognized a $29,000 gain on his 2017 tax return, he will record a $3,000 loss (calculated as $26,000 minus $29,000) on his 2021 tax return, treated as 60% long-term and 40% short-term capital loss.
In this case, 60% of traders’ annual earnings will be taxed at a fixed rate of 15%, while the other 40% will be taxed at the rate of the taxpayer’s tax bracket, which can range from 10% to 37%. This can be an attractive option for those traders with a 22% tax bracket or higher.
For example, Let’s say the trade has a $150,000 annual income. Let’s say that $30,000 out of $150,000 came in from Forex trading. Therefore, if he decides to file those earnings under section 988, then the effective capital gains tax will be 22%. Therefore, the total amount which should be paid in taxes will be $30,000 x 0.22, which is $6,600.
On the other hand, if he decides to file his trading earnings under section 1256, in this case, 60% of the amount, which is $18,000 out of $30,000, will be taxed at 15% and the remaining $12,000 will be taxed at 22%. Therefore, the total amount of tax will be $2,700 + $2,640, which is $5,340. So in this case he will be able to save $1,260.