The Motley Fool generally advises people to stay away from options, and invest only for the long term. However, we recognize that there's more than one way to make a buck on Wall Street -- even though some of those ways are much riskier than others.
Many investors speculate on the short-term movements of the market from time to time. That's why exchange-traded mutual funds (ETFs) have become so popular in the recent past. ETFs are similar to index mutual funds, but are traded as stocks on the American Stock Exchange. And, unlike index mutual funds, ETFs can be bought and sold at any time during normal trading hours, and can be sold short.
If you play the short-term swings in the market with these investments, you can get hit pretty hard from a tax standpoint. Short-term gains generated by investing in stocks (including ETFs) are taxed at ordinary rates -- as high as 35%. Of course, if you're into ETFs for the long term (more than one year), any gains will be taxed at favorable long-term capital gains rates, i.e., no higher than 15%.
If your ETF investments are generating a lot of short-term gains, consider investing in broad-based equity index options. Why? Because these investment vehicles are tax-favored.
Broad-based equity index options are considered IRC Section 1256 contracts. As such, any gain on the sale of these options are automatically treated as 60% long-term capital gain income and 40% short-term capital gain income. This is true regardless of how long you hold the index option. And it's also true regardless if you are "long" or "short" these index options.
"Big deal," you mutter. Well, it can be a big deal. Investing in 1256 contracts allows for a "blended" maximum tax rate on gains of only 23%. That's because 60% of the gain is taxed at a preferred capital-gain rate of 15%.
Consider the taxpayer in the 35% bracket. If this taxpayer has a net short-term gain from an ETF in the amount of $3,000, the tax on this gain will amount to $1,050. But if that same taxpayer generated a gain from a broad-based equity index option, that same $3,000 gain will only be taxed at $690 -- a tax savings of $360.
This gambit doesn't only apply to higher-bracket taxpayers. An investor in the 25% bracket who realizes a $3,000 short-term gain in an ETF will pay $750 in taxes. But a $3,000 gain on a Section 1256 equity index option contract will result in just $660 in taxes. While the total tax savings (in real dollars) might not sound significant, it still represents a savings of about 14%. If I told you that you could slash your taxes by 14%, you'd listen, right?
What exactly are broad-based equity index options? They are basically options that have nine or more components and meet certain weighting conditions. The bottom line is that the overwhelming majority of exchange-traded index options now count as "broad-based." These aren't obscure indexes. They include the Dow 10 Index, the Dow Jones Industrial Average, the Dow Jones Transportation Average, the Dow Jones Utility Average, the Russell 2000 Index, the Standard & Poor's 100 Index, the Standard & Poor's 500 Index, and many others.
But beware: If you're using ETFs as a long-term investment vehicle, then stay away from investing in broad-based equity index options. Why? If you hold your ETF long-term and realize a gain, you'll receive the preferred long-term capital gain rate on the entire gain. But if you invest in broad-based equity index options for the long term, you'll still have to realize any gain as 60% long-term capital gains and 40% short-term capital gains. So if you're in for the long haul, take the ETF route and leave the index options behind.
Investing in options (equity index options or otherwise) isn't for everyone. There are many downsides, which you can read about in our Fool FAQ on options. But if you're a savvy investor who does try to time the market or a segment of the market over the short term, consider this little tax-saving alternative.
Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.