Although futures trading has numerous advantages over stocks or ETFs, tax efficiency is one of the main reasons many traders choose to trade futures.
Due to the IRS classifications for markets such as futures under Section 1256, capital gains and losses are calculated at 60% long-term and 40% short-term.
This means that a futures trader can take 60% of his profits at the cheaper long-term tax rate, even if the contract has been held for less than a year. This is different from stocks or ETFs, where you are 100% taxed on your normal income bracket.
Find out more about the tax benefits of trading futures in this 3-minute video!
Long-term capital gains
The long-term capital gains tax rate is 0%, 15% or 20%, depending on your taxable income and registration status. For most retailers, 15% will be the rate used.
This means that 60% of your futures trading income is taxed at 15% instead of the normal tax rate.
If a futures trader has a 30% income tax bracket and reports $ 10,000 profit from trades for the year, $ 6,000 of that profit would be taxed at 15% while only $ 4,000 would be taxed at their regular tax rate .
$ 10,000 profit x 60% long term capital recovery rate = $ 6,000
$ 10,000 profit x 40% short term capital gain rate = $ 4,000
$ 6,000 x 15% tax rate = $ 900
$ 4,000 x 30% tax rate = $ 1,200
$ 900 + $ 1,200 = $ 2,100 total income tax
To understand this advantage over stock trading, if a trader reported the same $ 10,000 profit from stock trading in one year and were in the same tax bracket as the above futures trader, 100% of that profit would be reported as short term as capital gains and the full amount of income tax will be taxed.
$ 10,000 x 30% = $ 3,000 total tax on profits
In this example, the futures trader who benefited from IRS Section 1256 saw a 9% tax efficiency versus its stock trader counterpart, resulting in a net difference of $ 900 in his total tax burden from the trade for the year.
You can easily see the tax benefit of trading futures by looking at these hypothetical examples. While this is entirely hypothetical, the 60/40 tax rule would result in even more favorable tax efficiency if the above trader had an income tax bracket higher than the 30% used in this example.
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