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The 6-Figure Wash Sale Tax Nightmare and Other DIY Investor Horror Stories

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What You Need to Know

  • The rude awakening faced by some new retail traders at tax time has become a hot topic among advisors.
  • One advisor had a client come to him with a 500-page tax form.
  • Trading platforms do little to warn investors of tax consequences, Jeffrey Levine says; TD Ameritrade spotlights its investor resources.

Advisor and accountant Dan Herron got a large PDF from one of his clients via email this week.

“It’s from Robinhood, which is pretty common these days,” said Herron, who leads Elemental Wealth Advisors in San Luis Obispo, California. “But when I opened it, I was like, ‘Holy —-!’ Pardon my language. There’s 500-plus pages [to the 1099-B tax form], and … a lot of transactions, a lot of volume, from options trades to individual stock commissions to ETFs.”

This tax season, advisors say investors who traded on Robinhood and other do-it-yourself investment platforms last year are now getting a big shock from the often-overlooked side of investing: lengthy tax documents and potentially huge tax bills.

The platforms “gamify [investing] to where people think it’s just fun, and they’re just trading paper money or whatever,” Herron said. “One of the scary things [DIY investors are] now finding out is that, hey, 1099-Bs are real.”

(Robinhood did not respond to requests for comment about the matter as of press time.)

Herron and other financial professionals have been exchanging their views about these situations on social media recently. Another example, shared by advisor Brian Wruk of Transition Financial Advisors Group in Gilbert, Arizona, was posted to online forums for members of the Financial Planning Association and the National Association of Personal Financial Advisors; it later circulated on Twitter.

In his NAPFA post, Wruk explained that a DIY trader he knows, but is not his client, recently put his 1099-B information into TurboTax and “to his chagrin” had a $1.4 million in capital gains and a tax bill of “just over $800k … he never knew anything about the wash-sale rules.” (The investor traded on the TD Ameritrade platform.)

While the trader started out with $30,000 in his brokerage account, he had some $45 million — “yes, million” — in total trades and a net profit of $45,000, Wruk explains in the post. By trading on margin in 2020, the investor could execute multiple trades that added up to between $200,000 and $2 million some days.

“When it comes time to report those trades on your tax return, you’re going to owe a ton of money — because what you’re seeing … is that it’s all short-term gains,“ said Wruk in an interview with ThinkAdvisor.

“They’re not holding it for investment, so they’re not getting long-term capital gains treatment,” With a lot of wash sales, they’re disallowing a lot of losses. People are ending up owing a significant amount of money.“

Per IRS rules, investors can’t claim losses if they sell and buy the same or very similar securities within 30 days. “You can’t deduct losses from wash sales unless the loss was incurred in the ordinary course of your business as a dealer in stock or securities,” according to the tax agency.

More Investor Troubles to Come

The investor Wruk knows and Herron’s client are not anomalies, other advisors say.

“I would expect to see more of this going forward,” said Jeffrey Levine, lead financial planning nerd at Kitces.com and chief planning officer at Buckingham Wealth Partners, in an interview.

“The fact of the matter is that the rules are complicated and you don’t know what you don’t know,” explained Levine, a CPA and CFP. “Unfortunately, this [situation raised by Wruk] is a case of what you don’t know biting you in the butt after it’s too late. After the year ends, it’s too late to go back and fix these sorts of things.”

Levine agrees that the “gamification” of investing is a factor in these situations. Taxes are “probably the last thing anybody’s thinking about. They’re just having fun … ,” he added.

When asked about the DIY investor’s trading, a TD Ameritrade spokesperson said: “We offer a number of educational resources specific to wash sale rules, including in-platform videos and explainers and publicly available articles on our Ticker Tape blog.”

In addition, “to help our clients keep track of their TD Ameritrade transactions, … they can see their realized gains and losses on their cost basis page,” she explained. “Understanding this can be a complex issue, we invite clients with any questions to check out our tax resources page or contact a tax services representative by calling us … during standard business hours.”

More Tax Info, Options Needed

In Levine’s experience, “I’m not saying one doesn’t exist, but I’m not seeing a platform where you submit the trade and … there’s a flag that says, ‘Hey, you know, you’re making a wash sale. This will do X,’ or ‘This is going to have this impact, so talk to your tax professional’ or something like that.”

Typically, investors run into tax issues if and when they get a 1099-B form. That’s when they “see the adjustment column and all of a sudden [they’ve] got a whole bunch of wash-sale losses that are disallowed,” he explained.

For Christine Benz, director of personal finance for Morningstar, the cases being raised by advisors on social media are leading to “an open and healthy debate about how much platforms should interject themselves into [investor] decisions like this.”

When you pay your bills online through a banking platform and “mistakenly pay it again a week later, … it’ll send up a flare saying, ‘Hey, this is identical to another payment you just made. So, the question is how much should the [investing] platform get into putting guardrails around investors?” Benz asked.

Morningstar’s research has found that most investors “don’t do a great job from the standpoint of trading,” she said. “They don’t capture a fund’s full return, for instance. So, less trading is more when it comes to successful investing.”

The trouble goes beyond the wash-sale rule, Benz states: “Some basic knowledge of how accounting works and how income, short- and long-term capital gains work should be front and center on trading platforms,” she said. “I’d also like to see it be a little clearer when it comes to how firms are tracking cost basis. Sometimes this is buried in disclosures.”

Also important is the fact that “if you’re in a taxable account, every time you do the trade, you have a taxable event,” said James Angel, an associate professor at Georgetown’s McDonough School of Business. “The trading is free, but at the end of the year, you’ve got an awful lot of taxable events, gains and losses, and that can get real complicated, real fast.”

Investor Education

These issues give advisors more impetus to “educate the public and really make sure we keep pushing the message of long-term investing,” said Courtney Ranstrom, CFP, co-founder of Trailhead Planners.

While this approach isn’t exciting as the day-trading scene, “It’s our jobs to be relatively boring, and we should be making [investing] boring for our clients in a way that’s very good for them,” explained Ranstrom. “This way, they can focus on and realize their goals — around their children, their careers and retirement.”

DIY investor situations like the one raised by Wruk give advisors the chance “to warn people that trading is not a strategy,” says Dawn Santoriello, CFP, president of DS Financial Strategies. “It’s best to work with an advisor, since more [investors] get burnt than get lucky” when going it alone.

The case of the 20-year-old Robinhood investor who died by suicide nearly a year ago after an apparent negative balance of $730,000 in his account, in which he traded options and other products, “shows this is a huge problem,” says Santoriello, as is the possibility of having an $800,000 tax bill. “Most folks don’t know about the wash rule, and we want to inform people about it.”

To Herron, the big 1099-B forms and DIY investors’ lack of understanding about tax rules “is so frustrating.” While he appreciates the upside of technology overall, the advisor remains deeply concerned about DIY investors’ ability to get up and trading on apps “in like two minutes,” he says.

“There’s something to be said for having more financial education in this country where we hit people at an early age and showed them the pros and cons [of different investing approaches],” the advisor explained.

“Everybody needs to learn about certain things, but an $800,000 learning lesson seems outrageous,” he said. “We need to do better as a society with education to make sure that people know what they’re getting into.”

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