Can an Active Trader Have a Cash Balance Plan or Defined Benefit Plan? The Surprising Answer


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As a result of Covid, there has been a surge of stock trading activity. This includes day traders, options traders, bonds traders, etc.

Many of these folks have substantial gains as a result of the increased market volatility. But this leads to tax concerns.

With higher tax bills awaiting, many are searching for creative tax planning strategies. Often the question turns to whether an active trader can use a cash balance plan or defined benefit plan as a means to reduce that tax liability.

So can you do this? Fortunately, the answer is yes. But you have to make sure the right structure is in place.

Determining Trader Tax Status

The ability to use retirement plans depends on your tax status. There are a few options to consider:

  1. Simply classifying the gain or loss with investment intent.
  2. Trader tax status using the capital gains method; and
  3. Trader tax status using Section 475 mark-to-market ordinary gain and loss treatment.

First of all, the general default classification for investors does not allow for retirement plans. This is because there is investment intent with no earned income. The trades are simply classified as capital gains or losses. The short-term and long-term capital gains rates are applied in addition to capital loss provisions.

However, if a trader qualifies for trader tax status you are able to deduct ordinary business expenses. This includes many of the following:

  • supplies and office expenses
  • computer equipment
  • start-up costs
  • education fees
  • furniture
  • trading software
  • dues and subscriptions
  • research publications
  • and even certain home office expenses

Commissions represent transaction costs that are deducted from trading gains or losses.

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If structured as an S-Corp, you can have an accountable plan that will reimburse the employee/owner for home-office and other employee expenses. These are deducted on the S-Corp tax return (Form 1120-S).

Investment Intent?

Investors and tax trader status traders who use the default tax method (not Section 475 MTM), must consider “tax-loss selling” before the end of the year to lower capital gains. However, they must be careful to avoid wash-sale loss rules on any sales.

If a trader qualifies for tax trader status during the current year, he can deduct trading business expenses. The trader does not have elect trader status or create a new entity. However, Section 475 does require a timely election. Make sure that you discuss your trading status upfront with a qualified CPA.

Because the trading is only for investment intent, there can be no expenses deducted against the trading gains.

Trader Tax Status with Section 475 MTM

Qualifying traders using Section 475 mark-to-market (“MTM”) accounting will report ordinary gains or losses from trading activity on Form 4797. Section 475 trades are not subject to capital-loss limitations.

Scrabble pieces spelling TAX

MTM accounting will include unrealized gains and losses at year-end, so there is no need to do tax-loss selling on trading positions. Effectively, the positions held at year end are adjusted to fair value and a gain or loss is realized.

For 2021, consider a Section 475 election. This is due by April 15, 2021 for individuals and March 15, 2021 for existing partnerships and S-Corps. 

Using a 401k or defined benefit plan with an S-Corp

A qualified tax trading status can use an S-Corporation for the trading activity. This allows the trader so separately designate the trading activity in this entity. A sperate entity could be used for investment related trades.

The S-Corp structure will allow a variety of employee benefits for tax planning purposes. This includes officer health insurance and retirement plan deductions. The corporation is required to pay a reasonable officer wage and issue a W2. This wage is treated as earned income (subject to employment taxes) and can support a generous retirement plan.

The most common retirement structure is a solo 401(k) or a cash balance plan (a type of defined benefit plan). In most cases, we will combine both plans to supercharge the tax deferral. The 401(k) plan combines an elective deferral of $19,500 and also a “catch-up provision” of $6,500 for taxpayers age 50 and older. 

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Then the defined benefit plan will be layered on top of the solo 401(k) plan in what we call a “combo plan”. The defined benefit plan can offer contributions as high as $300,000 plus, depending on age and W2 income.

The profit sharing component of the 401k plan is limited to 6% with the combo. But together these plans offer substantial tax savings for qualifying traders. 

Recent Changes for Day Traders

But the news gets better. Thanks to the SECURE Act, defined benefit plans can now be opened up to the date the tax return is filed (including extensions). This allows an S-Corp to open up a plan before September 15th of a given year and make a contribution for the prior year as long as the return has not already been filed and a timely extension was filed.

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Set up for 2021 or 2022

But don’t wait until the deadline. Not only does the plan need to be established but the investment account needs to be opened and funded before the return is filed. So give yourself at least a month to get at that accomplished.

Final Thoughts

At the end of the day, active traders who qualify can use an S-Corp structure to pay themselves a reasonable wage under the law. With this wage comes employment taxes. However, it also qualifies as earned income which can then qualify the employee for employee benefits and a retirement plans.

All of this is good news for active traders, options traders, and day traders. Make sure you plan your tax and retirement structure properly and limit your current tax liability!

Paul Sundin

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