Many traders have substantial trading gains for 2023, and they might owe 2023 estimated taxes paid to the IRS quarterly. Unlike employers, which withhold taxes on wages, brokerage firms do not withhold taxes on trading gains. Depending on their specific tax situation, other taxpayers may be able to wait to make tax payments until April 15, 2024, when they file their 2023 tax return or extension.
The first three quarterly estimated tax payments were due on April 18, June 15, and September 15, 2023; the fourth quarter payment is due on January 16, 2024. Many new traders didn’t submit estimated payments for the first three quarters, waiting to see what Q4 brought. Also, some traders view skipping estimated tax payments as a margin loan with interest rates of 7% for Q1 and Q2 2023 and 8% for Q3 and Q4 2023. With full transparency at year-end, traders can better assess the payment they should make for Q4 payments to minimize their underpayment penalties and interest.
The safe-harbor rule for paying estimated taxes says there’s no penalty for underpayment if the total payments made equal 90% of the current-year tax bill or 100% of the previous year’s amount (whichever is lower). If your prior-year adjusted gross income (AGI) exceeds $150,000 or $75,000 if you are single/married filing separately, then the safe-harbor rate rises to 110% of the previous year’s tax amount.
Activity in Jan. 2024 can trigger wash sale losses for 2023, thereby creating more taxable income in 2023.
Suppose your 2022 tax liability was $40,000 and your AGI was over $150,000. Assume 2023 taxes will be approximately $100,000, and you haven’t paid estimates going into Q4. Using the safe-harbor rule, you can spread out the payment, submitting $44,000 (110% of $40,000) with a Q4 voucher on January 16, 2024, and paying the balance of $56,000 by April 15, 2024. This is a good option when compared to sending $90,000 in Q4 (90% of $100,000). Consider setting aside that tax money due on April 15, 2024, rather than risking it in the financial markets in Q1 2024. I’ve seen some traders lose the money they planned to use to pay taxes by trading it in the market. No money to pay your taxes causes trouble with the IRS. (See the example below.)
If your 2023 income tax liability is significantly lower than your 2022 tax liability, consider covering 90% of the current year’s taxes with estimated taxes. Check your state’s estimated tax rules, too.
In the above example, the trader should calculate the underpayment of estimated tax penalties for Q1, Q2, and Q3 on the 2023 Form 2210. Consider using Form 2210’s Annualized Income Installment Method if the trader generates most of his trading income later in the year. The default method on Form 2210 allocates the annual income to each quarter, respectively.
Learn more about estimated taxes at https://www.irs.gov/businesses/small-businesses-self-employed/estimated-taxes.
Here’s an example of what to avoid: Assume Joe Trader has massive capital gains taxes to pay for 2023. However, due to a market correction in early 2024 and being on the wrong side of many trades, Joe might incur significant capital losses in early 2024 in trading securities (equity options and equities). Unfortunately, Joe might lose much of the tax money he owes the IRS and state for 2023 taxes. Without an election, traders and investors will get stuck with a $3,000 capital loss limitation in 2024 and must carry over capital losses to subsequent years. However, Joe is eligible for trader tax status (TTS), so he submits a 2024 Section 475 election to the IRS by April 15, 2024, for ordinary gain or loss treatment with mark-to-market accounting to apply to his 2024 losses.
While this election won’t get back his tax money lost, the Section 475 election makes Joe’s 2024 trading losses “ordinary”; therefore, they will offset his other 2024 income, like wages and retirement plan distributions, thereby reducing 2024 taxes due. However, the 2017 TCJA legislation has an “excess business loss” (EBL) limitation in 2024 of $610,000 (married)/$305,000(other taxpayers). Business losses over the limit are considered EBL and become a net operating loss (NOL) carryforward, which offsets income of any kind in subsequent years. Unfortunately, TCJA doesn’t permit net operating loss (NOL) carrybacks for 2024. Before 2018, traders could carry back massive NOLs to replenish their trading capital and stay in business. The 2020 CARES Act suspended TCJA’s EBL and NOL changes for 2018, 2019, and 2020 and allowed five-year NOL carrybacks (i.e., a 2020 NOL carryback to 2015). TCJA’s EBL and NOL carryforward rules apply for tax years 2021 through 2028.
Traders and investors in futures contracts can consider a Section 1256 loss carryback election. Rather than use the 1256 loss in the current year, taxpayers may deduct 1256 losses on amended tax return filings, applied against Section 1256 gains only. It’s a three-year carryback; unused amounts carry forward. TCJA repealed most NOL carrybacks, so the 1256 loss carryback is a trader’s only remaining carryback opportunity.
Related webinar with recording on Jan. 10, 2024: Significant Tax Moves For Traders To Make in Q1 2024.
Star Johnson, CPA, contributed to this blog post.
