401k for short-duration trading account (tax benefits)?

Discussion in 'Taxes and Accounting' started by stockmarketbeginner, Jan 15, 2018.

  1. Hello,

    Short-term trades are taxed at ordinary income. But if you have a 401k, you don't have to pay taxes on capital gains until you withdraw.

    The IRS code says if you withdraw money from a 401k before retirement age, you have to pay a 10% penalty on top of the regular tax.

    But this one-time 10% hit could be a lot better than always having to pay ordinary income tax rates on short term trades. Plus you get to start with pre-tax money. A one-time hit of 10% at the end seems a lot better than a series of 25-30% income tax penalties along the way.

    401k plans are often sleepy buy-and-hold things, and you don't take any money out until retirement age. But you are allowed to have multiple 401k accounts, it seems like you could set up one of your 401k plans to actively trade in, then take the penalty at the end and still come out way ahead.

    It seems that the 401k hinges on how much you can contribute each year to all of your plans combined. I'm not seeing why you can't use one to actively trade in so you don't get clobbered with ordinary income tax charges at every turn in the road. If you don't need the money any time soon, it seems like a good way to be tax efficient with short term trading (i.e. trades of less than one year in duration).

    I haven't run the math fully on this, but do you see what I'm getting at?
  2. fan27


    For early withdraw, you have to pay a 10% penalty AND pay income taxes on either your short or long term gains. No free lunch there.
    Macallik and truetype like this.
  3. srinir


    add to the above, 401k withdrawals are considered as income, not capital gains as your first sentence suggests.
  4. Robert Morse

    Robert Morse Sponsor

    I would never recommend cashing in your 401K early. Is the account material? You can trade futures in retirement account if you open an account through a self directed IRA company like Midland IRA.
  5. Assume a 25% income tax bracket. Remember these are *short term* trades only!!! A few months at most. If you do these trades in a non tax-protected account, you have to pay 30% each time on every capital gain. Every year, your base capital gets chipped away at. That makes it hard for your base capital to snowball. But if you get to postpone paying taxes, you get to snowball your money. Even with the additional 10% tax, the benefit of the snowball is so great that it's worth it. Let's look at an example:

    Assume 5 years of trading.
    Year 1: gain 20%
    Year 2: gain 0%
    Year 3: lose 5%
    Year 4: gain 10%
    Year 5: gain 25%

    Case 1... pay as you go:
    You start with after-tax income. So you earned $1200 taxed at 25% = $900 to invest
    900(1.2) >> 1080 - .25(1080 - 900) = 1035
    1035(1)>> 1035
    1035(.95) >> 983.25
    983.25(1.1) >> 1081.57 - .25(1081.57 - 983.25) = 1056.99
    1056.99(1.25) >>1321.23 - .25(1321.23 - 1056.99) = 1255.27

    Case 2: pay later:
    You start with pretax income. So you get the full $1200 to invest:
    1200(1.2)(1)(.95)(1.1)(1.25) = 1881

    Then you have to pay the tax man:
    capital gain = 1881 - 1200 = 681
    tax on capital gain = .25(681) = 170.25
    penalty on capital gain = .1(681) = 68.1

    1881 - 170.25 - 68.1 = 1642.65

    Unless I did the math incorrectly, we see that "pay later including penalty" results in a *far* better outcome than "pay as you go": 1642.65 versus 1255.27.

    A 5 year return with zero gains would result in a worse outcome: 1200(.75)(.9) = 810 vs. 900. But if you are producing zero or negative returns over a 5-year period, then you are probably not good at short-term trading and should get out of the short-term game anyway.

    The numbers I put in are have an average non-compounded annual return of 10%: (20 + 0 + -5 + 10 + 25)/5 = 10. So this is definitely not an exaggerated or rigged 5-year return sequence. I think most short-term traders are expecting a 10% or higher return on their money. Otherwise, just put your money in an index fund.

    What am I missing here?
    Last edited: Jan 15, 2018
    MoreLeverage likes this.
  6. Overnight


    Then just take one extra trade over the year that nets you $1600 and you have paid that tax penalty.

    End of discussion.
  7. Robert Morse

    Robert Morse Sponsor

    Don't you also have to pay income tax on the withdrawal? If you take out $50,000 and you are in a 25% tax bracket, don't you have to pay $5000+$12,500= $17,500? That leaves you only $32,500 to trade with. You have to make a 53% return to just get back to $50,000. You should consult your tax specialist. The math does not work.

    Macallik likes this.
  8. sss12


    The sequence of your math equations are not correct.

    But, aside from that, active trading of most 401k plans is not possible within most company plans. (See RM post). What type of employer/plan are you referring to ?
  9. Where is the math not correct?

    Also, apparently you can actively trade in a 401K (unless zacks is wrong):

    Where the zacks article falls short is that it assumes you need the money right way... you are living off of your short-term trading. So you would be constantly paying ordinary income tax plus the penalty. It's pretty obvious that would be a bad idea. The article does *not* consider the case I am talking about: you actively trade, but do not withdraw for many years. This allows your money to snowball, and the benefit of the snowballing effect strongly overpowers the 10% penalty.

    If we were discussing withdrawing the money during retirement, I don't even think we would be having a debate. So we are talking about the 10% tax penalty. But the example I created shows how you would pay the penalty and still come out far ahead.
    Last edited: Jan 15, 2018
    MoreLeverage likes this.
  10. Robert Morse

    Robert Morse Sponsor

    You are not including paying income tax. Then you are taking a 10% hit with no real expectation you can make more money in a taxable account vs a pension. Then you have to pay taxes every year and have less to trade with than if you allow it to build. Sorry, but unless you need the money for food or school, this is a very bad idea.
    #10     Jan 15, 2018