The nature of covered call trading will produce quick, relatively small and taxable profits. There are a couple of pitfalls with writing covered calls that could result in higher taxes than you really need to pay. Watch out for these problem areas and keep your trading-generated tax bill to a minimum.
Short-Term Capital Gains
An investment or trading position held for one year or less will produce a short-term gain or loss. Short-term gains are taxed at your marginal income tax rate. Long-term gains -- held for more than a year -- are taxed at a lower, preferred rate. The typical covered call trade is established and runs for two to three months, possibly longer, but rarely as long as a year. As a result, the majority of your gains from covered call trading will be taxed at your marginal tax rate. At the time of publication, the highest long-term capital gain tax rate was 15 percent and the highest marginal income tax rate was 35 percent.
Save Your Dividends
The dividends from most corporate stocks meet the criteria to be qualified dividends and taxed at a lower -- maximum of 15 percent -- rate. For qualified dividends to stay qualified, you must own the stock shares for at least 61 days out of the 121 days centered on the dividend record date. If your covered call trade results in a dividend but the shares are called away short of the required holding period, you will pay your full marginal tax rate on that dividend payment. Manage your covered call trades to avoid the potential for this situation.
Save Your Long-Term Capital Gains
You may hold stock that you have owned for more than one year, have significant gains in the stock and you want to sell calls against the shares. If you sold the shares outright, the gains would be taxed at the lower, long-term capital gains rate. If you sell deep in-the-money calls against your shares, you negate the long-term holding period for capital gains. Deep in-the-money calls most likely will be exercised, calling your stock away and leaving you with a big tax bill. To avoid this situation, only sell out-of-the-money calls against your longer-term stock holding.
Minimizing the Tax Bite
Any losses you incur while trading covered calls can be used to offset the gains you make from other trades. Short-term losses are first matched against short-term gains when you complete your tax return, so get out of losing covered call trades early and remember to use those losses to reduce your tax bill. One way to avoid all of the covered call tax headaches is to trade covered calls with your IRA account. You do not need to track and report all of your gains and losses if you are placing the trades in your IRA account.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.