Options trading doesn’t come without tax implications, but there are ways investors can still optimize their after-tax returns with just a little bit of understanding.
In brief, options trading, as described by Forbes, is when investors make speculations on the future outlook of the stock market or securities, such as stocks and bonds.
This gives investors the opportunity to buy or sell an asset at a specific price by a specified date.
In the Canadian markets, investors can do options trading by opening an investment account, creating a plan and a contract, adding funds to the account, and then making a trade.
While options trading poses more risks, it can also boost your portfolio.
To that end, below are some approaches for investors to keep in mind to minimize your tax burden with options trading.
Key strategies
Holding period
A holding period essentially outlines the taxing options of capital gains or losses – whether it’s a short-term or a long-term holding period.
Short-term holding periods are under a year, while long-term holding periods are over a year without an expiration.
Putting it simply, however long an option is held also determines the tax that is paid on a capital gain. Any profits that are made when an asset is sold are taxable.
According to Turbo Tax, It is estimated that short-term capital gains are taxed the same as ordinary income and can range anywhere between 10 per cent to 37 per cent. These, of course, vary depending on individual circumstances.
Capital gains made from assets held for more than a year, however, are taxed at lower rates than short-term gains and income and are taxed between only 0 per cent and 20 per cent.
Wash-sale rule
Also referred to as the superficial loss rule, wash sale rules in Canada require a 30-day blackout period before and after the sale of securities should an investor want to claim a loss.
According to the Government of Canada, a superficial loss happens when an investor disposes of capital property for a loss and both conditions are met: someone you’re affiliated with buys or has the right to buy the same asset during the 30 days before the sale and 30 days after the sale; or you or the person affiliated with you still owns or has the right to buy the property 30 calendar days after the sale.
In other words, the superficial loss rule is put in place to prevent investors from falsely reducing their tax liability.
Using tax-advantaged accounts
Registered retirement savings plans (RRSPs) and tax-free savings accounts (TFSAs) hold varying benefits; it’s just a matter of determining which is best suited for your needs.
An RRSP is a retirement savings plan that you or your partner contribute to. When it comes to RRSPs, some of their key benefits include:
- Its contributions are tax deductible. This means RRSP contributions can be claimed on your tax return.
- Savings grow tax free, which means you will not pay taxes on any investment earnings if they stay in your RRSP account.
TFSAs are accounts for individuals 18 or older with a valid social insurance number to set aside money, tax-free, throughout their lifetime. Three different kinds of TFSAs exist, including a deposit, an annuity contract, and an arrangement in trust.
Advantages of TFSAs include:
- Not paying taxes on earnings
- No specific income requirements
- Not paying taxes on any withdrawals made
- Being able to hold onto the account plan throughout your life
There are restrictions, however, on how much money an individual can contribute to a TFSA on an annual basis, which is $7,000 per year as of 2024. Once the maximum contribution is made, a “contribution room” begins to accumulate, which is the difference between the aggregate maximum deposit allowed and what’s actually contributed.
If contribution limits are not met each year, that is then rolled over into the next year and added to the contribution room.
Qualified covered calls
A covered call is when an investor can make additional income with limited downside protection. Covered calls are a popular investment strategy for investors looking to combine upfront income and lower portfolio risk. Investors must have positions in the security.
In line with this, qualified covered calls are also tax-efficient. According to Mackenzie Investments, premiums received from covered call options are considered capital gains and are generally 50 per cent taxable at a marginal tax rate. It is believed this is more tax efficient than interest income or standard income, which is 100 per cent taxable.
Tax reporting
With all this in mind, when it comes down to filing your taxes, it’s important to keep relevant information on hand to stay in good standing and to avoid any audits.
Keep accurate records of your options trading and use tax software or consult tax professionals when the time comes to submit your taxes.
In summary
Options trading is a smart way to generate income for retirement, however tax efficiency is key for it to be successful.
Understanding what strategies work best for you is the first place to start and, from there, plan your trades strategically to minimize tax impact.
And, as always, seeking professional advice is vital for complex tax situations that will also help you maximize your returns.
Ready to put these tax-smart options trading strategies into action? BMO InvestorLine Self-Directed gives you the tools and resources to get started.
Open a BMO InvestorLine Self-Directed account today and start exploring ways to minimize your tax burden.
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This article is prepared as a general source of information and is not intended to provide legal, investment, accounting or tax advice, and should not be relied upon in that regard. If legal or investment advice or other professional assistance is needed, the services of a competent professional should be obtained. Information contained in this article does not constitute and shall not be deemed to constitute advice, an offer to sell/ purchase or as an invitation or solicitation to do so for any entity. The content of this article is based on sources believed to be reliable, but its accuracy cannot be guaranteed. BMO InvestorLine Inc. and its affiliates, sponsors and employees do not accept responsibility for the content and makes no representation as to the accuracy, completeness or reliability of the content and hereby disclaims any liability with regards to the same. Any strategies discussed, including examples using actual securities, quotes and price data, are strictly for illustrative and educational purposes only and are subject to change without notice. BMO InvestorLine Inc. is not responsible for the information provided and disclaims all liability with regards to the same.
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