Retirement Tax Strategy: Are You a Trader or Investor?

Retirees often earn most of their income from their investments. As such, interest, dividends and capital gains often pay the bulk of their expenses.

Some retirees devote so much time and attention to their investment portfolios that they believe investing has become their job or business.

And that begs the question:  Can a retiree – for tax purposes — be in the business of investing?

Well, that depends on whether the IRS views you as an investor, or a trader…

There are tax benefits when investing is your trade or business, which the IRS calls being a trader.

All your investment-related expenses are deducted directly from investment income on Schedule C. You might even be able to deduct a home office expense.

Unlike most Schedule C taxpayers, the net income from trading isn’t subject to self-employment tax. But a trader can’t deduct Keogh retirement plan contributions.

A trader also has the advantage of electing to mark-to-market all investment positions at the end of each year.

This means you report gains and losses as though you sold each position on the last day of the year, though you haven’t.

So, if you have a net loss on paper at the end of the year, you have a net loss for tax purposes (even though you haven’t sold your positions, and today’s paper losses might turn into gains next year.)

Under this election, you can also deduct net losses against other income without being subject to the $3,000 annual limit other taxpayers face.

A disadvantage of being a trader is you don’t receive the preferential long-term capital gains rate. All net gains and losses are ordinary income or losses.

Because the tax advantages of being in the trade or business of investing can be substantial, the IRS and courts tightly limit who qualifies as a trader instead of an investor.

Whether you’re an investor or trader depends on your time perspective, your goals, the type of income you earn, and the amount of transactions you undertake.

To be a trader, your investment activity must be substantial and must be carried on with regularity and continuity.

You also must seek to profit primarily from daily (or less frequent) market movements and not primarily from interest, dividends, or capital gains.

The IRS will examine the amount of time you devote to investing and whether you are pursuing the activity for a livelihood.

But the key factors are the frequency and dollar amount of your trades during the year and the typical holding period for a security. You must pass all the tests to be considered a trader.

There have been court cases in which taxpayers engaged in more than 200 trades per year but weren’t considered traders.

The reason:  Either their trading wasn’t regular or continuous, or because they weren’t trying to profit from daily market movements.

In a fairly recent case, the taxpayer made 204 trades one year, 303 the next and 1,543 the third year.

The Tax Court said trading for the first year wasn’t substantial, but it was substantial for the next two years.

The taxpayer’s strategy was to buy stocks and then sell call options on them. The goal was to earn premiums as the options expired without the buyers exercising the right to buy the stock from the taxpayer.

The taxpayer generally held options for one to five months and did not trade them daily. The taxpayer executed trades on 77 days the first year and 99 and 112 days in the following two years.

The court ruled the trading wasn’t frequent, continuous, or regular.

Adding all the factors together, the court said the taxpayer wasn’t a trader. (Endicott v. Commissioner., T.C. Memo 2013-199)

There’s no precise formula for being considered a trader for tax purposes, but there are some general rules that can be developed from the cases.

To be a trader, you probably need to execute trades on at least 300 days per year and should execute more than one trade on many days.

You also need to trade for short-term profits, so your strategy and goals matter. Your average holding period should be measured in hours, days or weeks, not months or years.

You’re more likely to be considered a trader if you trade options or futures contracts instead of stocks, bonds, ETFs, or mutual funds.

Also, you can be an investor for some of your securities and a trader for others. If you’re trying to do that, you should use separate brokerage accounts for the two types.