Minimize Your Tax Bill with Index Options

Options traders seeking exposure to specific indices have a variety of instruments to choose from. Index and ETF options provide investors with a selection of contract sizes and characteristics for the same underlying. While most investors choose a product based on convenience and size, investors should also be aware of critical tax-saving strategies when building a portfolio. In this post, we will explore the tax advantages of trading Index vs. ETF options on the Nasdaq-100 Index.

Investors trading in a taxable account has to account for long- and short-term capital gains tax. The tax rate will depend on both holding periods and net income levels. Let’s review the tax implications of common investment asset classes:

Equity Trading: Short-term vs. Long-term Gains:

• Profits from Stocks held for less than one year are subject to Short-term Capital Gains, which match your regular income tax rate.
• Profits from Stocks held for more than one year are subject to Long-term Capital Gains, which are either 0%, 15%, or 20%, depending on your income and filing status.

Long-term capital gains tax rates are typically lower than short-term capital gains tax rates. Therefore, if you are interested in reducing your tax burden when trading equities, consider holding stocks for more than one year.

Dividends

• Dividends are classified as either non-qualified (ordinary) or qualified. Non-qualified dividends align with your regular income tax rate. Qualified dividends can be 0%, 15%, or 20% depending upon your income and filing status. IRS Publication 550 outlines details regarding dividend exceptions and special rules.

What if I am holding my stocks in a Traditional IRA, 401k, or Roth IRA?

• Dividends and Capital Gains earned within a Traditional IRA or 401k are tax-deferred, while dividends and capital gains earned within a Roth IRA are tax-free.

If you’ve discovered the power and versatility of options trading, chances are you want to maximize the benefits, especially when it comes to reducing the taxes owed.

Equity Options Trading (ETF and Stock Options)

• When traded in a taxable account, gains on most Equity Options trades will result in a short-term capital gains rate, otherwise known as your ordinary income tax rate. Only options positions held for longer than one year are subject to long-term capital gains rate.

I enjoy trading options. Is there a way to avoid paying regular income taxes when trading this type of contract?

Index Options Trading: 

• The IRS categorizes index options as a Section 1256 Contract, which has associated tax benefits. Regardless of the amount of time you hold a 1256 contract, gains are treated as a 60% long-term capital gain and a 40% short-term capital gain. These contracts cap the maximum tax rate of an index option at just 26.8% at the current tax rates.

For most options investors, ETF and Index options on the same index may seem fungible and traded interchangeably. However, there are not only tax differences but also assignment and exercise risks to consider. With American style physically delivered ETF options, there are early assignment risks with option strategies containing a short leg. Additionally, exercise risk at expiration can cause significant risks in rare cases. Trading European-style cash-settled index options eliminate all of these risks with tax benefits added on top. Historically one limitation of index options was the size, suited only for institutional investors.

However, with the Micro Nasdaq-100 Index Options (XND) launch, retail traders can access all of the benefits of index options in a retail-friendly size. Nasdaq’s full suite of Index Options products allows traders of all account sizes to embrace the flexibility and benefits offered by trading index options—including tax benefits not provided by stock or ETF options trading.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

In This Story

NDX

Other Topics

Taxes