According to industry reports, there are more than 130,000 tax preparation businesses with nearly 300,000 employees in the United States. For the sake of comparison, that’s roughly the amount of every employee (globally) for both Microsoft and Meta, combined. There’s a lot of people that work in tax prep and they just finished the most hectic period of the year.
Why are so many people dedicated to this relatively narrow, seasonal endeavor?
In short: complexity and importance.
- It’s important to the government: The U.S. federal government collects roughly $5 trillion in revenue per annum. Individual income taxes account for ~50% of the government’s total revenue.
- It’s significant to individuals and corporations: Individuals pay between 10% and 37% in tax, depending on their income bracket. Corporations are generally subject to a federal tax rate of 21%, with additional state and local taxes.
- It’s complicated: The Internal Revenue Code (IRC) contains nearly all federal tax laws and more than 800 types of tax forms/schedules. In total, the document (available online) is 70,000+ pages long. Context on the length: War and Peace (Lo Tolstoy) is roughly 1,565 pages depending on font/print. So, the tax code is nearly 45 times the size of War and Peace.
Complexity lends itself to specialization. The economy rewards deep domain knowledge, and it’s played out across industries from healthcare, to finance, to…taxes. We’re going to pay taxes, so for most people and corporations, it’s about paying the least amount permissible within the legal framework. Last year, I wrote about the politics that supported the early growth in index derivatives.
Reagan Revolution
Back in the early 1980s, the derivatives world was a niche marketplace. The equity and fixed income markets were much more mature by comparison. The first cash-settled futures contract (Eurodollars) started trading in 1981. The following year, the Chicago Mercantile Exchange (CME) introduced Stock index futures. In early March of 1983, the first cash-settled index option product also began trading in Chicago.
These innovations spawned a growing ecosystem around equity indexes and other important financial markets. Dan Rostenkowski was a congressman from the state of Illinois, whose district included headquarters for the CME, Chicago Board of Trade (CBOT) and Chicago Board Options Exchange (CBOE).
By the 1980s, Rostenkowski rose to serve as Chairman of the Ways and Means Committee. That was a powerful role, and he was able to influence the tax overhaul bill during the first Reagan administration. To help support his constituents and growth in the derivatives markets, Rostenkowski carved out section 1256 contracts.
You can read about the potential tax benefits of broad-based index options (and a handful of other derivative products) on the IRS’ website.
Control What You Can
Most tax filers have a limited degree of flexibility regarding their annual submission. Tax filers’ income from employment is typically the bulk of their earnings. The total tax burden may fluctuate depending on their filing status (married/single/head of household) and standard deductions. In many situations, there’s relatively little an individual or family can do to reduce their tax burden. They might work with a financial advisor, save more aggressively in tax-advantaged retirement accounts and use a Certified Public Accountant (CPA) to feel confident they are maximizing deductions and minimizing their overall taxable income.
As income increases and an investible asset base grows, these considerations become more meaningful. I am NOT a tax professional (I work with a CPA), and you should consult with a specialist.
trading Choices & Tax Implications
The tax code treats gains and losses from some investment vehicles differently than wages from employment. Typically, delineation is a matter of holding period. For example, if an investor holds an equity (single name security/ETF) for 365 days or more, the potential gains from that investment should be considered “long-term” capital gains. That’s contrasted with the potential gains from the same security held for less than a year. In that situation, the gains would be considered “short-term” which carries a higher tax rate.
Let’s understand the first key point. There are differences between short- and long-term capital gains. The differentiation is a matter of whether the security was held for at least one full year.
- Short-term capital gains are generally taxed at the same rate as ordinary income. As such, the tax burden will be somewhere between 10% and 37% depending on your tax bracket.
- Long-term capital gains are typically taxed at a lower rate. Long-term capital gains vary from 0% to a maximum of 20%.
The same holds true for most, but not all equity options. In other words, if you hold an equity or ETF option for less than 365 calendar days, the potential gains from that transaction will be taxed at your ordinary income rate (higher). If an equity or ETF option is held for longer than a full year, then it should receive lower, long-term gains status (maximum of 20%). You should consult a tax advisor about these distinctions.
Individual use of equity options has boomed in the past few years. So too has the use of index options. The overwhelming majority of options are held for less than 365 days. In fact, many option traders have gravitated toward index products because there are far more granular expiration cycles available for trading.
That’s not the only potential benefit of choosing an index option as opposed to an ETF option designed to track the same index. Let’s understand why with an example.
ETF vs. Index Options
The Invesco QQQ ETF (QQQ) is designed to track the performance of the Nasdaq-100® Index (NDX). There are actively traded QQQ options that many investors use to gain exposure, hedge against adverse market moves, potentially increase portfolio yield or manage cash flows.
From a tax perspective, any potential gains from a QQQ option held for less than 365 days will likely be taxed at the ordinary, short-term rate (higher).
Nasdaq-100® Index Options (NDX) and Nasdaq-100® Micro Index Options (XND) are also designed to track the performance of the NDX®. Both NDX® and XND® index options are considered broad-based index products (1256 Contracts), which is important from a tax perspective. To learn more about the differences (notional) between the two NDX® index options, Click here.
Index options, like NDX® and XND®, should qualify for favorable tax treatment. In other words, gains from these products should be taxed as 60% long-term (lower) and 40% short-term (higher) independent of the holding period.
Hypothetical Example
Let’s assume two option users are exclusively focusing on NDX®-tracking products.
- Trader A only uses QQQ options.
- Trader B only uses NDX® (or XND®) index options.
Both traders fall in the 35% income tax bracket.
For the sake of simplicity, let’s assume that both traders generate $100,000 in profits in a calendar year (and no options were held for 365+ days).
Trader A will likely have their gains taxed entirely at their ordinary income rate (short-term) = 35%.
Trader B will likely have 60% of their gains ($60k) taxed at the long-term rate of 20%, and 40% of their gains ($40k) taxed at the short-term rate (35%).
The illustrative potential implications are outlined below.
|
Trader A (QQQ) |
Trader B (NDX®/XND®) |
|
| Profits |
$100,000 |
$100,000 |
| Short-Term Rate (35%) |
$35,000 |
$14,000 |
| Long-Term Rate (20%) |
$0 |
$12,000 |
| TOTAL LIABILITY |
$35,000 |
$26,000 |
You can see from the example that there’s a material difference in the total liability from the same profit amount simply as a function of which optionable product was used.
The blended tax rate for Trader B, who understands the potential benefits of 1256 Tax treatment, worked out to 26%.
The rate for Trader A, who used only equity/ETF options (held for less than a year) was 35%.
The above examples are hypothetical. You should consult a tax advisor about your tax implications.
Wrap Up
Taxes are a part of life. As Benjamin Franklin wrote in 1789: “In this world nothing can be said to be certain, except death and taxes.” There’s only so much we can control when it comes to taxes, but the product choices we make when considering index-tracking risk management tools can have significant implications. Index options generally receive preferential tax treatment when compared to very similar equity or index-tracking ETF options.
Index options are not for everyone. Market participants should understand the different notional exposures, as well as the other unique attributes typically associated with index products. They are cash settled, European styled and may have more breadth of expiration cycles on top of the potential tax benefits.
Talk to your tax advisor and see if you could benefit from using index options, like NDX® and XND®.
