What do they mean for financial planning strategies? Proprietary trading (prop trading) can be a lucrative endeavor for the right type of investor, however it brings a unique set of tax implications that have far-reaching effects on financial planning strategies. Prop trading does not make one as much profit in a direct sense as traditional investing; it is complex because income comes from different types of income, deductions, and more debits too! Prop traders need to understand these tax implications so that they can maximize their financial results and remain compliant with the tax laws.
How Prop Trading Income Is Taxed
Income Writer vs. Capital Gains
The core difference of prop trading income in terms of tax treatment lies in whether it is treated as ordinary income or capital gains. This designation alters income tax rates:
Ordinary Income: Often, the income from prop trading is fully taxed as ordinary income, which carries a higher tax rate than that of capital gains. This includes salary, bonuses, and the like that are paid out by the prop firm.
Capital Gains: Part of a trader’s earnings from trading could be classified as capital gains if the trader is considered an independent contractor or self-employed, and those may enjoy a lower tax rate (especially if the gains qualify as long-term gains held for more than one year).
Self-Employment Taxes
If the prop traders are 1099 or corp-to-corp, you will have to contend with self-employment taxes. This is on top of the employer and employee Social Security and Medicare taxes, so this can be a big hit to your final tax bill if you inherited a decent amount.
Revenue Split and Performance Captures in Profit Split
In prop trading firms, profit splits and performance bonuses fall under ordinary income tax. Traders should expect to save a portion of their income for tax purposes.
Itemized and Business Write-Offs
Home Office Deduction
Home office deduction: Prop traders trading from home may be able to deduct a portion of their homeowners’ expenses—rent, utilities, and maintenance—based on the square footage percentage that is used exclusively for trading.
Trading-Related Expenses
Prop traders are eligible to deduct a number of trading-related expenses from their taxable income. These expenses may include:
- Hardware and Software: Computers, monitors, trading platforms (e.g., NinjaTrader $800), software subscriptions.
- Data Fees: Market data, news services, and possibly other information sources you need to trade.
- Formal Education and Training: The costs of courses, seminars, and books that specifically help you improve as a trader.
- Professional Fees: Payment to an accountant, tax advisor, or legal professionals in respect of trading.
Entity Structure
Entity structure (e.g., sole proprietorship, LLC, S-Corp) can also affect the deductions available and overall tax liability. This might include the potential for greater tax savings through income splitting and other strategies as well as simplified deduction rules that apply to a variety of business expenses, which could give these LLCs or S-Corps a competitive advantage.
State and Local Taxes
Of course, prop traders must also take into account state and local tax obligations in addition to federal taxes. This differential impact can significantly affect the total tax burden due to different types of trading income and how it is taxed.
State Income Tax
In some states, there is no state income tax while in others the percentage of your paycheck taken out for taxes can be high. Traders must know the tax rules for their state of residence and its impact on conducted net income.
City Taxes
While some cities have an additional income tax imposed on such a level of earnings, people trading in these cities have to plan for those taxes also.
International Considerations
Additional considerations for prop traders will only arise if they trade in international markets or are non-resident with their home country.
Foreign Earned Income Exclusion
Many U.S. taxpayers qualify for the Foreign Earned Income Exclusion (FEIE) that permits them to exclude up to a specific dollar value from their worldwide earnings on their U.S. tax return. Nevertheless, there are boundaries to this exclusion as well as requirements it needs to satisfy.
Tax Treaties
Inter-country tax treaties can affect the taxation of trading income and reduce double taxation. It is essential for traders to understand any treaties and how they affect their tax liability.
Reporting Requirements
International trade can result in other reporting obligations such as the Foreign Bank Account Report (FBAR) and the FATCA. Adhering to these requirements is important if you want to stay out of trouble.
Financial Planning Strategies
Financial planning is an essential part of prop trading due to the complexity in taxation. Some solutions to consider:
Regular Tax Payments
Prop traders need to pay estimated tax payments throughout the year in order to avoid penalties and interest. This means calculating the estimated income tax due from trading activity and other sources of income and completing four payments to the IRS (and any respective state obligations) throughout the year.
Tax-Advantaged Accounts
Prop trading income is not usually available for direct contribution to tax-advantaged retirement accounts like IRAs or 401(k)s, but active traders can utilize Solo 401(k)s or SEP IRAs if they trade through a business entity. Self-directed accounts allow for tax-deferred contributions that can be considerable based on self-employment earnings.
Loss Harvesting
Strategic realization of losses (also known as tax-loss harvesting), so that traders can offset gains. This includes unloading assets that are performing poorly and selling them for losses that can be applied towards tax duties to bring down total taxes.
Professional Advice
I recommend hiring a tax professional that specializes in other income (trading and investment income) because it is complex! A tax advisor can help you find the ins and outs of the tax code, locate which deductions you qualify for, and create a financial plan that suits your unique needs.
Record Keeping
Having well-organized, relevant records of everything from trading to expenses and income is imperative. It also helps with the supporting documentation you will need for your tax returns and if ever you get audited.
Conclusion
Prop Trading & Taxes: Complex, but critical to financial planning! Income classification, self-employment taxes, deductions, and international considerations are among the themes traders need to navigate. And prop traders can do just that by working to mitigate such pressures now so as to not sometime later face them more intensely, through thoughtful strategies like regularly paying taxes (and budgeting for it), using tax-advantaged accounts wherever possible, and seeking competent advice (counter-intuitive reminders included). Being cognizant of and taking control of these tax implications is crucial to long-term prop trading success in the ever-changing prop landscape.
