Don't worry, we're going to cover those here and make it as straightforward as possible.
Earned income
Earned income includes wages, salaries, bonuses, and tips. It's money that you make on the job. But even if day trading is your only occupation, your earnings are not considered to be earned income. This means that day traders, whether classified for tax purposes as investors or traders, don't have to pay the self-employment tax on their trading income. Isn't that great?Maybe. Maybe not. The self-employment tax, the bane of many an independent businessperson, is a contribution to the Social Security fund. The problem is that if you don't have earned income, you aren't paying into Social Security, which means that you might not be eligible for retirement benefits.
To collect benefits, you have to have paid in 40 credits, and you can earn a maximum of four credits per year. Most employees do this easily, but if you have taken time off work or have a long history of work as an independent investor, you may not have paid enough in.
Any benefits you do collect are based on the 35 years of highest earned income over your work history. Your years of independent trading show up as years with zero earned income, and that might hurt your ultimate benefit.
Investment income
Investment income is your total income from property held for investment before any deductions. This includes interest, dividends, annuities, and royalties. It does not include net capital gains, unless you choose to include them. Do you want to include them? Well, read the next section.Other than net capital gains, which you might or might not decided to include, most day traders have very little investment income for tax purposes.
Capital gains and losses
A capital gain is the profit you make when you buy low and sell high. The opposite of a capital gain is a capital loss — selling an asset for less than you paid for it. Investors can offset some of their capital gains with some of their capital losses to reduce their tax burden.Those who trade frequently will have many capital gains and losses, though, and they may very well run afoul of complicated IRS rules about capital gains taxation. When designing your trading strategy, think long and hard about how much pain taxes might cause.
The financial world is filled with horror stories of people who thought they found a clever angle on making big profits, only to discover that their tax liability was greater than their profit. In the real world, taxes matter.
Capital gains come in two flavors: short term and long term. You're charged a low rate on long-term capital gains, which right now is defined as the gain on assets held for more than one year. How low? It's 15 percent right now. Short-term capital gains, which are those made on any asset held for one year or less, are taxed at the ordinary income rate, probably 28 percent or more.