It can be hard to understand the differences between taxes on stock options and taxes on mutual funds. However, an understanding of both will help you understand whether an investment is a good fit for your financial needs. Mutual funds are designed as pool vehicles where investors pool their money to buy shares of stock. When the funds are invested in a variety of companies, the investor earns a large lump sum each year. Because of the earnings potential, mutual funds have been popular for many years.
A different story is told when talking about taxes on stock options. In the U.S., taxes on capital gains and dividends are deducted from a person’s income on a regular basis. This includes annual dividends. Dividends are not taxable income, but capital gains are subject to capital gains tax.
Some investors choose to invest in individual stock options. With individual stock options, the investor has the option of investing in one security or a basket of securities. If the investor opts to invest in the securities that are in a tax-deferred account, he or she will be taxed only once and never have to pay taxes on the gains. For this reason, individual stocks can be very attractive to a savvy investor. The difference between a regular savings account and a self-directed IRA account is the presence of the tax-deferred component.
There is one major difference between taxes on stock options and taxes on mutual funds: the option price is not tax-deductible. Mutual funds are not required to be held by individuals. Investors are only required to purchase shares on a monthly, quarterly, or yearly basis. They do not have to hold the shares throughout the year. This reduces the tax liability on the purchase and allows investors to take advantage of low-interest rates.
Individual stocks can be very attractive but they are not as tax-efficient as mutual funds. If an investor were to invest the funds and then let the funds grow at a high rate, he or she would be taxed on the gains. By investing in individual shares, the investor is able to defer taxes on stock sales until the money is ready to be taxed. Because mutual funds have a very high annual return, the resulting gain may not be worth the amount deferred. For this reason, it is important for people to talk with a qualified financial advisor before deciding whether or not to invest in options trading.
Options trading also requires an investor to track and calculate expenses. An investor’s costs will include the commission paid to the broker, costs associated with buying and selling stock options, and taxes. Some states also require an investor to pay additional taxes on the gains on stock options. Some investors choose to invest in tax-deferred plans such as retirement annuities. A tax-deferred plan allows individuals to delay paying taxes on stock options until the plan has reached its maturity, which can sometimes be several years.
An important consideration when deciding if stock options trading is right for an investor is whether the taxes on the gains are greater than or less than the taxes on the capital gains in the future. Capital gains taxes are figured into a tax calculation based on the sale price of the stock at the time of purchase and do not include any future gain. Options trading strategies can result in large capital gains during the time of purchase but these gains cannot be realized until the option expires. Some investors may find that paying taxes on stock options is higher than they want to pay because they expect the gains to offset the taxes on stock dividends received. When dividends are included in an ordinary income plan, the taxes on the dividends are usually paid by the brokerage account. However, in a tax-deferred plan, the capital gains are deferred until they are realized. The brokerage account pays the taxes on these gains; hence, the option is not realized until the gains are realized.