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Traders should consider general year-end planning strategies like deferring income and accelerating expenses, but they should also be aware of some other special tactics. In this article, I touch upon 20+ ideas for tax savings on your 2014 tax return.
1. Avoid NIT if you can.
As of Jan. 1, 2013, if you have adjusted gross income (AGI) over $250,000 (married) and $200,000 (single), then additional investment income will be subject to the 3.8% Net Investment Income Tax (NIT). (Read Net Investment Income Tax.)
2. Accelerate income to utilize lower tax brackets
There are some situations where it’s better to accelerate income and defer expenses, such as if you happen to be in a low tax bracket in 2014 due to trading losses and or other types of expenses and losses. Take advantage of ordinary tax rates up to 28%, a good regular tax rate and the highest alternative minimum tax (AMT) rate.
If you hold a security for 12 months before selling, it’s considered a long-term capital gain subject to rates that are lower than the ordinary rates for short-term capital gains. Look in your investment portfolio for positions with material unrealized capital gains. Consider selling some or all of the long-term winners before year-end. The long-term capital gain tax rate is graduated: 0%, 15% and 20%. The 0% rate applies up to $73,800 of taxable income for married filing joint and $36,900 for single filers. The long-term rate applies to qualified dividends, too.
3. Accelerate more income with a Roth IRA conversion
Another good way to accelerate income to utilize lower tax brackets is by executing a Roth IRA conversion before year-end. You can break up an IRA into pieces in order to convert a certain amount. You can always recharacterize the conversion in 2015 if it doesn’t work well — for example, if you lose the money in the Roth account and prefer a do over or if your tax rates in 2015 are far lower than 2014. (Read our Oct. 7 blog Last chance to reverse 2013 Roth IRA conversion by Oct. 15, 2014.)
4. Get a handle on wash sale loss deferrals
Wash sale loss deferrals accelerate income if you don’t have a capital loss limitation. Many taxpayers hate wash sales because they cause tax liability on phantom income, with the IRS deferring losses into the next tax year.
Smart investors, business traders and investment managers spend November and December identifying and avoiding potential wash sale losses on “substantially identical positions” (i.e., between Apple stock and Apple options at different strike prices). Don’t wait until you receive broker-issued Form 1099-Bs in February to find out you have a huge tax problem with wash sale loss deferrals which might increase your 2014 tax bill significantly. (Read Cost-Basis Reporting and Form 8949.)
5. Use Tradelog to better manage wash sales
Run TradeLog software before year-end to calculate and avoid wash sales, handle cost-basis reporting correctly and generate Form 8949 for tax filings. Keep running it through the end of January for wash sale loss calculations since they are triggered 30 days before and 30 days after taking a loss (if you re-enter that position). TradeLog’s “Potential Wash” report can be used to avoid wash-sale loss surprises. Once you spot a potential wash sale, sell all open positions before year-end and don’t buy them back for 31 days. (Read Accounting Solutions and purchase Tradelog.)
6. Break the chain on wash sales with an entity
Consider trading in a separate entity in Q4 or on Jan. 1 to disconnect your individual trades under a different taxpayer ID number for the entity. A single-member LLC (SMLLC) disregarded entity doesn’t work here; you need a partnership or S-Corp return. (Read Entity Solutions.)
7. Avoid wash sales in IRAs
Don’t forget to run TradeLog on your individual IRA accounts too. Avoid permanent wash sale losses between individual taxable accounts and IRAs. Don’t trade substantially identical positions between taxable and IRA accounts.
8. Take advantage of tax loss selling
Most financial media recommend “tax loss selling” as part of year-end tax planning. If you have capital gains year-to-date, sell a few losing positions to reduce capital gains taxes. Remember, don’t rush to buy back that losing position within 30 days (in January) as that can cause a wash sale loss deferral at year-end 2014, thereby defeating the purpose of tax loss selling.
9. Hold winning positions at year-end
Investors, business traders and hedge fund managers often hold open winning positions in securities with unrealized gains at year-end in order to defer taxes and perhaps achieve lower long-term capital gains rates in 2015 or subsequent years.
10. Utilize capital losses to maximum advantage
If you have significant capital losses and carryovers in 2014, consider selling open winning positions before year-end to utilize those capital losses. There’s no sense holding a winning position open for 12 months to achieve a long-term capital gain if that gain is offset with a capital loss carryover.
Per tax publisher Thompson Reuters, “Long-term capital losses are used to offset long-term capital gains before they are used to offset short-term capital gains. Similarly, short-term capital losses must be used to offset short-term capital gains before they are used to offset long-term capital gains. A taxpayer should try to avoid having long-term capital losses offset long-term capital gains since those losses will be more valuable if they are used to offset short-term capital gains or ordinary income.”
11. Section 475 traders are exempt from wash sale rules
Business traders should learn about Section 475 MTM business ordinary gain or loss treatment. While short-term capital gains on securities are taxed at ordinary rates, short-term capital losses are subject to the $3,000 capital loss limitation and problematic wash sale loss rules. The main tax benefit of Section 475 is that 475 trading losses are business ordinary losses without any limitation, and are included in net operating loss (NOL) calculations. Section 475 trades are exempt from the wash sale rules, too. New taxpayers (entities) are entitled to elect Section 475 within 75 days of inception, so this is a good solution for traders late in the year. (Read Section 475 MTM Accounting.)
12. Turn 2014 unrealized capital losses into 2015 ordinary losses
If business traders qualifying for trader tax status don’t have Section 475 in 2014, they can elect it for 2015 by April 15, 2015. That 2015 election converts unrealized business trading gains and losses at the end of 2014 into ordinary gains or losses on Jan. 1, 2015 — that’s the required Section 481(a) adjustment. A negative Section 481(a) adjustment on Jan. 1 from unrealized losses on Dec. 31, 2014 is far better than a capital loss carried over from 2014 to 2015. In this case, wash sales are good because they are part of a Section 481(a) adjustment, rather than being a capital loss carryover. Traders generally have a hard time using up large capital loss carryovers. In this case, the business trader wants to skip tax loss selling and it’s beneficial to have an unrealized capital loss at year-end.
13. Learn the rules for segregation of investments
Some business traders and many hedge fund managers skip Section 475 MTM elections because they have a hard time following the rules for “contemporaneous” segregation of investments from business trading positions. The IRS is increasingly challenging traders over the segregation of investment rules. Hedge fund managers also don’t want investors paying taxes on open positions, as investors would request redemptions to pay the tax bill while managers have cash funds tied up in those open positions. (Read our Aug. 13 blog IRS warns Section 475 traders.)
14. Assess your qualification for trader tax status
Section 475 hinges on trader tax status (TTS), so active retail traders and hedge fund managers should assess their qualification before year-end. Sole proprietors and hedge funds can claim TTS after they assess the facts and circumstances, but Section 475 MTM is not allowed after the fact. It had to be elected with the IRS by April 15, 2014 for 2014 or within 75 days of a “new taxpayer” (i.e., a new entity) filed in the entity books and records (an internal election). (Read Trader Tax Status: How to Qualify.)
15. Forex can be ordinary or capital treatment
By default forex receives Section 988 ordinary gain or loss treatment. Forex traders may file an internal contemporaneous election (known as a forex “capital gains” election) to opt out of this treatment. Major forex forward contracts for which regulated futures contracts trade on U.S. futures exchanges are labeled “foreign currency contracts” under Section 1256(g). Section 1256 has the tax benefit of lower 60/40 tax rates: 60% is subject to lower long-term capital gains rates and the other 40% is taxed at ordinary rates. Section 1256 is mark-to-market at year-end, whereas Section 988 is realized transactions only. We make a case for treating forex spot like forex forwards in Section 1256(g). (Read Forex tax treatment.)
16. Decide whether to accelerate or defer expenses.
Currently, 2015 tax rates match 2014 rates. This means if you are in a high tax bracket it’s a good idea to defer income and accelerate business expenses and itemized deductions. (Using credit cards on the last days of the year counts.) You may not qualify for TTS in 2015, so get business deductions while you still can. Investment expenses exclude home office, education, and startup costs. (Business expenses allow them.) If you don’t qualify for TTS at year-end but will in 2015, then defer business expenses to 2015.
17. Get employee-benefit plan deductions with entities
Trading gains are not considered earned income, so traders need an entity to pay the owner/trader compensation to unlock valuable employee-benefit-plan tax deductions, including retirement and health insurance premiums. (Traders generally save thousands of dollars with these strategies.) S-corps and C-corps should execute payroll and partnerships administration fees before year-end. To avoid under-estimated tax penalties, increase tax withholding through year-end payroll. (Read Entity Solutions and watch our Oct. 22 Webinar recording Year-End Planning with Trader Entities.)
18. Establish retirement plans before year-end
Business traders should open an employer 401(k) plan before year-end in an S-Corp trading entity or C-Corp management company — otherwise, they will miss the boat on the best retirement plan choice for most traders. The 401(k) elective deferral of $17,500 is 100% deductible, plus it’s paired with a 25% employer profit-sharing plan allowing a total contribution of up to $52,000. There’s also a $5,500 catch-up contribution for taxpayers age 50 and over. For sole proprietors, an Individual 401(k) plan has a 20% profit sharing plan, which is not as generous as the employer 401(k) plan.
Make sure to pay compensation before year-end to execute these employee-benefit plan deduction strategies. High income traders should consider a defined benefit (DB) plan where you can contribute much higher amounts per year (up to $210,000 for 2014). DB plans require actuaries and attorneys and it takes time to set up. Consider different options for your retirement plan contributions, and whether you have sufficient cash flow to maximize this tax deduction. Can you afford a Roth contribution too? See 2014 retirement plan limits on the IRS site (click here for DB plans). Don’t overlook required minimum distributions (RMD) rules for traditional retirement plans. (Read Retirement Solutions and watch our Oct. 22 Webinar recording Year-End Planning with Trader Entities.)
19. Get a handle on accounting first
Focus on accounting before year-end to get a proper handle on tax planning. Accounting for securities trading is complex with cost-basis reporting, wash sales and reporting realized gains and losses only. We recommend Tradelog software to download your trades and handle this accounting.
20. GTT Tracker app for expense accounting
For expenses and asset purchases, we recommend our GTT Tracker accounting solution and app. Account for expenses and assets, including fixed assets (equipment), intangible assets (software), Section 195 startup costs and Section 248 organization costs. GTT Tracker prepares a full accounting and it properly documents your trading expenses and other business expenses. It’s a single-entry accounting system that is extremely effective and easy to use. The software allows you to download bank account and credit card transactions and follow IRS rules for compliance and documentation on a daily basis. Don’t be stuck trying to remember who you had dinner with and what the business purpose was at year-end. The IRS is tough on these issues in exams. (Read GTT Tracker with GTT TradeCounter.)
21. Expenses must be in order by year-end
Execute expense reimbursements before year-end — a requirement in S-Corps and suggested in partnerships. Learn how to handle the health insurance premium deduction, which is tricky with S-Corps. Employee-benefit plan deductions determine the amount of compensation needed to unlock those deductions. S-Corps should consider using salaries in December and engaging a payroll processing firm — we recommend paychex.com.
22. Get your Obamacare matters in order
Obamacare health insurance mandate tax penalties apply on 2014 tax returns for the first time. Many traders may qualify for penalty abatement under a financial hardship exemption. Many have also received notices to repay all or a portion of health-exchange subsidies received. There’s a whole new batch of Obamacare tax forms to fill out, and the first year will generate a lot of confusion.
23. Consider a C-Corp
A C-Corp is taxed separately from individuals and the top C-Corp tax rate (35%) is lower than the top individual tax rate (up to 44% with NIT). But there’s also double taxation with C-Corps: once on the entity level and again when qualified dividends are paid on the individual level. Double taxation is less of an issue in states with no individual income tax.
There are a number of ways to get income into the C-Corp. House intellectual property there, charging your trading entity royalties. Have the C-Corp get a profit allocation from the trading entity. Have the C-Corp charge the trading entity administration fees. C-Corps can have a medical reimbursement plan, which is a good way to pay for high deductible Affordable Care Act-compliant health insurance plans.
24. Catch up with estimated taxes at year-end
Don’t forget to get caught up with your 2014 estimated income taxes. Many traders underpay estimated taxes during the year, considering the underestimated tax penalty like a low-cost margin loan. The Q4 estimate is due Jan. 15, 2015, so you can see where you stand at year-end first. Consider paying the state(s) before year-end for another 2014 tax deduction, unless you trigger AMT and don’t get that benefit.