While there are numerous benefits to trading futures over equities or ETF’s, one of the key drivers moving many traders into futures trading is tax efficiency.
Due to the IRS classifications on markets such as futures under Section 1256, capital gains and losses are calculated at 60% long-term and 40% short-term.
This means a futures trader can take 60% of their profit at the more favorable long-term tax rate even if the contract was held for less than a year. This is unlike equities or ETFs where you are taxed 100% at your normal income bracket.
Learn more about the tax advantages of futures trading 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 filing status. For most individual traders, 15% will be the rate used. This means that 60% of their income from futures trading will be taxed at 15% rather than their typical tax bracket rate.
If a futures trader is in a 30% income tax bracket and reports a $10,000 profit on 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 gains rate = $6,000
$10,000 profit x 40% short-term capital gains rate = $4,000
$6,000 x 15% tax rate = $900
$4,000 x 30% tax rate = $1,200
$900 + $1,200 = $2,100 total taxes on profit
To understand this benefit when compared to equities trading, if a trader reported the same profit of $10,000 from equities trading in a year and was in the same tax bracket as the futures trader above, 100% of that profit would be reported as short-term capital gains and be taxed the full income tax amount.
$10,000 x 30% = $3,000 Total taxes on profit
In this example, the futures trader benefiting from IRS Section 1256 experienced a 9% tax efficiency over their equities trader counterpart, resulting in a $900 net difference in their total tax burden from trading in the year.
You can easily see the tax benefit of trading futures just by looking at these hypothetical examples. While entirely hypothetical, if the trader above was in a higher income tax bracket than 30% used in this example, the 60/40 tax rule would result in even more favorable tax efficiency.
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