The Hidden Price of Trading Often: Taxes

Those big profits that so many individual investors racked up last year by aggressively trading stocks sure looked sweet on Dec. 31.

But come April 15, they might not look quite so spectacular.

Propelled by Internet-stock mania, dirt-cheap online brokerage commissions and the rise in overall market volatility, legions of individual investors began actively trading stocks last year in search of fast profits.

But as tax time approaches, many people could be confronted with a stark reality: a shockingly high tax bill that will make those world-beating numbers look decidedly middle-of-the-pack.

The reason is simple: Capital gains realized on any security held for less than a year are taxed as “ordinary income” at federal marginal tax rates that can run as high as 39.6%.

That means frenzied traders could shell out almost twice as much in taxes as long-term investors, who pay a 20% maximum federal tax rate on capital gains realized on securities held at least 12 months.

“I’ve got some clients who on their own made 14% or 15% or 16% [trading individual stocks], and I point out that on an after-tax basis they’re making 8%,” said Joel Framson, a CPA and certified financial planner at Los Angeles-based Glowacki Framson Financial Advisors. “They can’t believe it because they’re seeing only the gross numbers.”

Moreover, the tax bite is far worse in high-tax states such as California, where the top marginal tax rate on ordinary income and on capital gains is 9.3%.

Traders have a couple of other things going against them. People who haven’t kept meticulous records might have to scramble to reconstruct some trades. And active traders also face the prospect of higher tax-preparation fees because of the extra time accountants will need to go through their documents.

As more people catch the trading bug, accountants say they’re seeing many clients who need help sorting out the tax consequences of their newfound hobby.

“I see it more and more and more,” said Phil Gautschi, a partner at Irvine CPA firm Martin, Lamb, Morton & Perle. “Even though they know the rules, it’s the excitement of the chase. They’re so involved with [trading] and they’re working so hard to create profitable results, they often don’t remember about the 12-month holding period” for the lower capital-gains tax rate.

Because 1998 is over, it’s too late to take many of the steps that could otherwise be taken to reduce tax liability--such as offsetting capital gains with losses. However, there is one important move that investors can take now: Pay any estimated taxes owed as soon as possible.

People with steady jobs generally have federal and state taxes withheld from their paychecks, in line with their pay levels. Others must pay estimated taxes four times a year, making the payment directly to the federal government and/or to the state.

Estimated taxes are most often owed by people whose income is sporadic, such as freelancers. But investors who reap large one-time gains, such as from stock trading, also can be subject to the requirement.

Investors who fail to make these payments on time can be hit with big penalties from the Internal Revenue Service and the state.

In general, an investor can avoid a penalty as long as the taxes he or she paid in 1998 equal the taxes that were due in 1997.

For example, if an investor paid $30,000 in taxes in 1997, he would be able to avoid a penalty in 1998 if the taxes paid for the year, either through withholding or through timely estimated-tax payments (or both), equaled $30,000--even if the ultimate liability is higher when the final tax bill is calculated by April 15.

The estimated-tax issue is all the more critical this tax season because many investors reaped their greatest profits during the fourth quarter as the stock market surged back from its summer dive and as the Internet stock mania exploded.

The fourth quarter’s estimated-tax payment was due Jan. 15. If you missed making the payment, do so as soon as you can: If you pay now rather than on April 15, “the penalty would be significantly lower,” Gautschi said.

For help in determining any estimated taxes owed and any penalty owed, get IRS Form 2210, “Underpayment of Estimated Tax by Individuals, Estates and Trusts.” To pay the actual taxes, fill out Form 1040-ES and mail it in with a check to the IRS.

Likewise, check to see if you owe California estimated taxes. (Instructions are readily available from the Franchise Tax Board.)

Records for Trading Can Be Voluminous

Active traders also can do themselves a favor by organizing their records before they walk into the accountant’s office. That saves time for the tax preparer and money for the investor.

Indeed, tax preparation fees can be quite hefty for an active trader. Regardless of whether an investor made several dozen or several hundred trades last year, every transaction must be listed individually on federal Schedule D.

“All those have to be shown separately on a tax return,” noted David Flamer, a CPA and partner at Lasher, Flamer & Associates in Woodland Hills. “It takes a lot of time.”

One idea to shave costs: As long as the format is identical to Schedule D, a computer-savvy investor could print out all trades on an Excel work sheet, Gautschi said. The accountant could attach the printout to the tax package instead of having to spend time regurgitating the data on a Schedule D, he said.

As is the case any year, any losses realized in selling securities during the year can be used dollar-for-dollar to offset capital gains. But all those transactions had to have been completed by Dec. 31 to qualify for the 1998 tax year, of course.

What if, instead of hefty capital gains, you wound up with net capital losses last year?

You can apply as much as $3,000 of net capital losses to reduce 1998 adjusted gross income, which is the amount from which a final tax bill is figured. Losses that exceed $3,000 can be set aside and applied to capital gains, or adjusted gross income, in future years.

Investors unlucky enough to incur huge capital losses can use them to offset big future capital gains, Flamer noted.

Imagine that a married couple this year sells their longtime residence for a $700,000 profit. Federal law allows the couple to exclude the first $500,000 from taxes. But the remaining $200,000 would be taxable, Flamer said.

If, however, the couple had a $100,000 capital-loss carry-forward from several years earlier, they could use that to trim in half the tax liability on their capital gain. Capital-loss carry-forwards never expire.

What You Can Do for the Future

Though active stock traders can’t do much now to change their 1998 tax bills, they can use some of the lessons they’ve learned to reduce the taxes they’ll owe in the future.

One reminder to file away for November is to inventory your realized gains and losses by Dec. 1, and determine whether it’s worth selling other poor-performing investments to offset realized gains for the year.

But the more obvious issue is determining whether it’s better to sell out of a winning stock in the short term, or hold onto it for the long-term tax treatment.

There’s no easy answer to that question, of course, but tax experts note that on a pretax basis, short-term traders must achieve much higher returns than their long-term-investor counterparts to end up with the same level of after-tax profit.

“When you add in the transaction costs and the tax costs, a trader who is in the highest tax bracket would have to outperform the buy-and-holder by 2 to 1,” said Mitchell Freedman, head of Mitchell Freedman Accountancy Corp. in Sherman Oaks.

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Times staff writer Walter Hamilton can be reached by e-mail at walter.hamilton@latimes.com.