Many new investors view day trading as an efficient way to earn funds quickly. The idea behind the concept is to make trades over short periods to take advantage of short-term price changes while profiting at the same time.
The results of day trading may surprise you, though, as it can result in losses or substandard returns for the vast majority of traders. It can have large impacts on your taxes, too.
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Factors that drive day trading behavior
A few key factors have popularized day trading. Looking at historical data makes day trading look easy, while technology makes day trading easier to access and cheaper than ever before.
You may also hear news shows with investment segments quoting successful experts in sound bites — but they typically don't highlight the resources experts have available or their decades of experience, which can mislead viewers. Finally, many investors seem to only speak about their successes and not their failures.
Day trading taxes: How the costs could exceed the gains
Successful day traders need access to several tools to outperform the markets. They typically pay for an investment trading platform and purchase tools that offer research, charting, and other functions necessary to trade profitably.
While brokerage fees are mostly disappearing, some firms still charge fees on certain transactions. Any brokerage fees that must be paid, quickly add up when you buy and sell investments many times per day. Regulatory fees, although small, add another cost.
Some day traders use margin, or debt, to leverage their trades. This creates the potential for higher gains while exposing traders to the risk of larger losses. Investors have to pay interest and may have to pay other fees to use margin, too.
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How day trading impacts your taxes
A profitable trader must pay taxes on their earnings, further reducing any potential profit. Additionally, day trading doesn't qualify for favorable tax treatment compared with long-term buy-and-hold investing.
In rare cases, dedicated day traders can apply for special day trader tax treatment with the IRS, which can potentially reduce some tax impacts while at the same time potentially making any net profits subject to self-employment tax. For everyday investors who don’t qualify for any tax benefits, the following rules may apply:
- You're required to pay taxes on investment gains in the year you sell.
- You can offset capital gains against capital losses, but the gains you offset can’t total more than your losses. You can use up to $3,000 in excess losses per year to offset your ordinary income like for example, wages, interest, or self-employment income on your tax return and carry any remaining excess loss to the following year.
- If investments are held for a year or less, ordinary income taxes apply to any gains.
- Holding an investment for more than a year usually allows traders to take advantage of lower long-term capital gains tax rates.
- Capital gains distributions and dividend distributions require investors to pay taxes in the year these distributions are paid out.
- Long-term investors may avoid or defer these taxes by holding their investments in a tax-advantaged account, such as a 401(k) or Roth IRA.
Investing long term could help to solve day trading issues
Experts often consider long-term investing a better investment strategy than day trading. Long-term investors can take advantage of long-term capital gains tax rates, which can help them save money on taxes. If you hold your investments within a tax-advantaged account, you may receive even more tax benefits.
Long-term investors usually invest in diversified portfolios rather than concentrated positions. Diversified portfolios that aren't touched often perform better than traders who miss the top ten performing days during the year.
By investing for the long term, you could help to grow your money faster without the heightened risks, costs, stress, and extra headaches associated with day trading. That said, the future is uncertain, and investing is inherently risky. Ultimately, you must come up with the best investment plan for your situation.
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