How to Avoid Taxes on Options Trading: LEAPS, 60/40, and IRAs

There is no way to erase federal tax on a winning options trade, but there are several legal ways to pay a much lower rate on it. If you want to know how to avoid taxes on options trading at the highest bracket, the biggest levers are trading broad-based index options that qualify for the Section 1256 60/40 rule, holding LEAPS contracts more than a year to reach long-term capital gains rates, running your options inside an IRA or Solo 401(k), and harvesting losses against your gains. Full-time traders can go further with a mark-to-market election. Each of these has boundaries, and getting them wrong costs more than doing nothing.

The starting point is the rate you are trying to beat. Options profits are capital gains, and most options positions close within weeks or months, so most profits are short-term gains taxed at your ordinary income rate — up to 37% federally in 2026.¹ Higher earners add the 3.8% Net Investment Income Tax on top once modified AGI exceeds $200,000 single or $250,000 married filing jointly, taking the top combined federal rate to 40.8%.² Every strategy below is a way to pay less than 40.8%.

Trade Index Options for the 60/40 Rule

Section 1256 of the Internal Revenue Code taxes certain contracts on a fixed split: 60% of the gain at the long-term capital gains rate and 40% at the short-term rate, no matter how briefly you held the position.³ A day trade gets long-term treatment on most of the profit.

For a trader in the top bracket, 60% at 20% plus 40% at 37% works out to a blended federal rate of about 26.8%, versus 37% on equivalent short-term equity gains. With NIIT layered on, that is 30.6% instead of 40.8%.

The catch is what qualifies. Section 1256 covers “nonequity options,” which in practice means cash-settled options on broad-based indexes such as SPX (S&P 500), NDX (Nasdaq 100), and RUT (Russell 2000). Options on individual stocks do not qualify. Options on ETFs do not qualify either, even when the ETF tracks the same index — SPY options are ordinary equity options for tax purposes, while SPX options get the 60/40 split.³ For an active trader, moving from SPY to SPX is often the single largest tax move available.

One thing to know: Section 1256 contracts are marked to market at year-end. Any position open on December 31 is treated as sold at fair market value that day. You report the results on Form 6781, and the totals flow to Schedule D.⁴ You cannot defer an unrealized gain into next year, but the blended rate more than makes up for it.

Hold LEAPS More Than a Year

LEAPS are options with expiration dates as far as three years out. Because you can actually hold them long enough, they open the door to long-term capital gains rates on an equity option. The rule is the same one that applies to stock: hold the contract for more than one year before selling, and the profit is taxed at 0%, 15%, or 20%.⁵

The gap is large. A top-bracket trader who closes a LEAPS call at day 364 pays up to 37% on the gain; two days later, that drops to 20%. On a $50,000 profit, that is the difference between $18,500 and $10,000 before NIIT. Most traders who lose this deduction lose it by closing a few days early. Check the trade confirmation against the original purchase date before you sell anything near the one-year mark.

LEAPS work best as a stock replacement: buy a deep in-the-money long-dated call, get similar upside with less capital committed, and hold past the anniversary.

Trade Inside a Retirement Account

The cleanest way to keep options profits out of your current tax return is to earn them inside an IRA or Solo 401(k). A Roth IRA is funded with after-tax dollars and grows tax-free; qualified withdrawals in retirement are not taxed at all. A Traditional IRA or Solo 401(k) offers a current deduction on contributions and defers tax on gains until you withdraw.

Contribution limits cap how much capital you can move in each year. For 2026, IRA contributions are limited to $7,500, or $8,600 at age 50 and older.⁶ A Solo 401(k) allows up to $24,500 in employee deferrals plus employer profit-sharing, with a total cap of $72,000 under age 50. You need earned income to contribute to any of them.

Brokers restrict what options strategies you can run inside a retirement account. Covered calls and cash-secured puts are usually allowed. Spreads may be permitted at some brokers. Selling uncovered (naked) calls is almost universally prohibited because the loss potential is unlimited. A useful side benefit: trades inside an IRA are not reported on Schedule D, which removes a significant paperwork burden for active traders.

Harvest Losses Against Your Gains

Losing trades have tax value. Capital losses offset capital gains dollar-for-dollar in the same year, and up to $3,000 of any excess loss can reduce ordinary income, with the rest carried forward indefinitely.⁵ If you have realized short-term gains on the year, closing losing positions before December 31 is one of the most straightforward tax moves available.

The wash sale rule is the trap. Close a position at a loss, then buy a substantially identical option within 30 days before or after the sale, and the IRS disallows the loss for that year. The disallowed amount is added to the basis of the replacement position, so you get it back eventually, but not on this return.⁷ Buying back a call at the same strike and expiration you just sold at a loss is the textbook trigger. Rolling a losing position to a different strike or expiration can also cause a wash if the new contract is substantially identical, and the statute does not draw a bright line on that question for options.

Constructive Sales When Locking In Gains

The mirror image trap catches traders trying to protect a profit. If you hold an appreciated position and enter an offsetting trade that eliminates virtually all your risk, Section 1259 can treat the hedge as a “constructive sale” and tax the gain immediately, even though the original position is still open.⁸ The statute names options as covered positions. Hedging a winner into next year to defer tax can produce the opposite result.

Watch the Straddle Rules on Multi-Leg Trades

If you hold offsetting positions on the same underlying, the IRS may call the combination a straddle. Under Section 1092, when offsetting positions substantially reduce your risk of loss, a realized loss on one leg is deductible only to the extent it exceeds the unrealized gain on the other leg.⁹ You cannot take the losing side of a spread as a current-year deduction while letting the winner ride into January. Iron condors, strangles, and other multi-leg strategies need to be tracked with this rule in mind, because it can quietly wipe out a loss harvest.

Elect Mark-to-Market If You Trade as a Business

Traders whose activity rises to a genuine trade or business can elect mark-to-market accounting under Section 475(f). Gains and losses become ordinary income and loss.¹⁰ That sounds worse until you look at the loss side: ordinary business losses are not capped at $3,000 a year and can offset any type of income. For a trader with a bad year, that is a much larger deduction than the capital loss rules allow. The election also removes wash sales as a practical concern, because year-end mark-to-market treatment reaches the same result the wash rule would.

Qualifying is not automatic. The IRS looks for frequent, regular, substantial trading aimed at short-term price movement, not investing for dividends or long-term appreciation. There is no bright-line test, and the determination is made on the facts and circumstances of each case.¹¹

The deadline is strict. You must file the election by the due date, without extensions, of the return for the year before the election is to take effect. To be a mark-to-market trader for 2027, you file the election with your 2026 return by April 15, 2027. The statement must identify the election under Section 475(f), the first year covered, and the trade or business. New taxpayers not required to file a return for the prior year have two months and 15 days from the start of the election year. Miss the window and you usually wait a year.¹¹

The trade-off is real. Ordinary income treatment gives up the preferential long-term capital gains rate on winning years, and mark-to-market at year-end prevents deferral of unrealized gains. The election pays off for traders whose losing years genuinely need full deductibility more than their winning years need the lower rate.

Pay Quarterly So Penalties Don’t Eat the Savings

Options profits do not have tax withheld at the source. The IRS expects estimated payments each quarter if you will owe at least $1,000 after withholding and credits, unless your withholding covers the smaller of 90% of the current year’s tax or 100% of the prior year’s (110% if prior-year AGI was over $150,000).¹² Underpayment triggers an interest-based penalty assessed quarter by quarter.

Traders with lumpy income, a big Q3 winner and quiet quarters on either side, can use the annualized income installment method on Form 2210 Schedule AI to match payments to the quarter the income was actually earned instead of paying in four equal amounts. State estimated payment rules run in parallel and carry their own penalties, so check both.

1
Internal Revenue Service. Federal Income Tax Rates and Brackets
2
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
3
Office of the Law Revision Counsel. 26 U.S. Code 1256 – Section 1256 Contracts Marked to Market
4
Internal Revenue Service. About Form 6781, Gains and Losses From Section 1256 Contracts and Straddles
5
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
6
Internal Revenue Service. Retirement Topics – IRA Contribution Limits
7
Office of the Law Revision Counsel. 26 USC 1091 – Loss From Wash Sales of Stock or Securities
8
Office of the Law Revision Counsel. 26 U.S. Code 1259 – Constructive Sales Treatment for Appreciated Financial Positions
9
Office of the Law Revision Counsel. 26 USC 1092 – Straddles
10
Office of the Law Revision Counsel. 26 USC 475 – Mark to Market Accounting Method for Dealers in Securities
11
Internal Revenue Service. Topic No. 429, Traders in Securities
12
Internal Revenue Service. Large Gains, Lump Sum Distributions, Etc.