Top 15 Questions about Trading in an IRA

Monday, December 8th, 2014 | Vance Harwood
 

Based on searches that lead people to Six Figure Investing, these are the top investment questions people ask about IRAs.  For definitive answers on tax questions in your specific circumstances please consult a tax professional.

General

  • Why trade in an IRA?   Because it allows you to defer or avoid taxes on dividends and capital gains—all of your profits can be reinvested tax free.
  • What trading restrictions / rules are there for IRAs?   The only universal restriction is tied to IRS rules that do not allow borrowing from an IRA account.  This restriction blocks short selling, leverage using margin, and the sale of naked put or call options.  Brokerage firms vary in what they allow, but generally you can trade all stocks and exchange traded products (ETFs & ETNs) including leveraged (SSO),  inverse (e.g., SH), and volatility funds (e.g., VXX, XIV, ZIV).  Some trades such as options, leveraged/inverse funds, volatility funds, or futures might require extra paperwork / qualification.
  • What specific restrictions/features do brokers put on their IRA accounts?   Data on a few brokers:
    1. E*TRADE and optionsXpress: Futures not supported
    2. Fidelity:  Futures not supported
    3. Interactive Brokers and TD Ameritrade:  Limited margin for avoiding settlement date restrictions
    4. Schwab: No options spreads, futures not supported
    5. Thinkorswim:  Looks pretty open, including futures
  • Are the trading rules different between a Roth IRA and a Traditional IRA?  There are no differences that I’m aware of.



Day Trading

  • Can I day trade in my IRA account?  Typically there are no pattern day trader restrictions on IRAs that have a value of more than $25,000.  However frequent trading in a cash account (typical for IRAs) can lead to violations of the 3 day trade settlement rule.  Unless you are only trading a small percentage of your account balance you will quickly run into settlement problems.  If you break these rules you will get “free riding” or “good faith” warnings/violations (SEC Regulation T violations) that will cause restrictions to be put on your account.  See “Trading in an IRA and avoiding free-riding” for more information.
  • Is there an easy way to avoid “free riding” in my IRA account?   Only buy when you have enough “settled funds” in your account (usually visible in your on-line balances) to cover the purchase. Interactive Brokers and TD Ameritrade have limited margin features for avoiding settlement date restrictions—they essentially waive the 3 day settlement period.



Stock/ ETF/ ETN trading

  • Can I buy stocks on margin in my IRA?  Not if you are trying to get leverage.  While some brokers offer IRAs with limited margin, that capability is only there to manage options strategies and avoid cash settlement issues.
  • Can I sell stocks short in an IRA?   No, but you can buy inverse Exchange Traded Products (ETPs) like SDS (-2X S&P 500) or SH (-1X S&P 500).   With options you can often nearly replicate a short position—by buying puts, or call spreads with the short side deep in the money.
  • Can I buy leveraged or inverse ETF / ETNs  like SSO (2X S&P500) in my IRA?   Most brokers allow this. You may have to sign a waiver or be qualified first.
  • Can I buy volatility ETNs/ETFs like VXX, UVXY, and XIV in my IRA?  Most brokers allow this.  You may have to sign a waiver or be qualified first
  • Can I use a stop loss order in my IRA account?   Yes, but for stocks / ETPs you should wait 3 days after your purchase to put it in place if you used unsettled funds for the purchase.  Otherwise you run the risk of violating the SEC’s free-riding rules if the stop loss triggers.  See this post for more information.



Options

  • Can I trade options in my IRA account?  You need to be qualified and allowed trades vary between brokers, but yes you can—except for selling naked calls or puts—the highest risk category.
  • What happens if options in my IRA are assigned?  Option assignment can be a problem if it not covered by cash or offset by other positions in your account (e.g., stock in the case of a covered call, or an offsetting assigned option).   For example, if the short side of  your vertical spread is assigned when the underlying goes ex-dividend your account will go short the equivalent amount of the underlying—not a sustainable situation for an IRA account.   You must cover the short quickly, but unless you have sufficient settled cash in your account you may get a “free ride” violation.   A call to your broker if this situation occurs would be a very good idea.  It might be possible in this case to wait one day before covering and avoid the violation.  Unbalanced option assignment can also happen when the options in a spread expire with one leg in the money and the other OTM. Cash settled options  (e.g. SPX, VIX) don’t have this problem.  See Trading in an IRA and avoiding free-riding and Options strategies in Your IRA Account for more information.
  • Can I sell puts in my IRA?  You can sell cash secured puts in your IRA if you have approval for that level of options trading from your broker and you have enough cash in your account to buy the requisite amount of the underlying security (100 shares per option) if your puts are assigned.

 

Taxes

  • Can I write off a trading loss in my IRA on my taxes?  Generally no.  Only if you have liquidated the account and your distribution was less than the amount you contributed.  Of course the converse is also true; you don’t have to pay taxes on gains.  The IRS always seems to have exceptions so check with your tax advisor if you’re doing anything unusual.
  • Will my dividends or capital gains be taxed in my IRA? No, taxes on dividends and capital gains are either deferred (traditional) or avoided (Roth) in an IRA.
  • Can I write off commissions on my trades within my IRA?  No, the tax exemption cuts both ways.  There’s no way to write off expenses like commissions or management fees.


Trading Restrictions in an IRA

Sunday, October 19th, 2014 | Vance Harwood
 


IRAs are attractive to investors because they enable taxes on dividends and profits to be deferred (traditional IRA)  or avoided (Roth).   To a large degree you can do the same trades in an IRA that you can do in your regular accounts.  However there are significant differences, and the differences change over time as brokers adjust their policies, and their software.   I’ve tried to summarize the differences below.

Brokers vary in what transactions they allow in your IRA, but one restriction mandated by the IRS is that you cannot use your IRA as security/ collateral for a loan.   Getting leverage using margin and selling equities short involves using the assets in your account to secure the loans so those trades are definitely out in an IRA.

The no-loan restriction can also impact how often you can trade in your IRA account.   Since funds from equity sales take 3 days to settle, just like a regular non-IRA account, you can run into free-riding/ good faith violations if you do  buy / sell sequences before your previous trade’s settlement.   Some transactions like stop loss orders or option assignments can sell out your positions automatically, so you need to assess the risks of that happening within 3 days of your purchase.  For more on free-riding see this post.

If you only buy securities when your account shows enough cash to cover the purchase as “settled cash”, or “cash available to withdraw” then you won’t violate the rules—even if you sell it five minutes later.  It’s only when you are dependent on an upcoming cash settlement from a previous sale that you have to be careful.  So if your cash balance is large compared to your trade size (e.g., $10K cash, $2K trades), then you could do up to 5 trades in a 3 day period before you had to worry about the settlement timing.

If you are trading indexes then the short sale restriction is often easy to circumvent by buying the corresponding short or leveraged short, 2X, 3X ETF (e.g, SH, SDS, SPXU for the S&P 500, PST and TBT for treasuries).    In my experience any stock/ETF/ETN that can be bought in my regular account can be traded in an IRA account—so for example long, leveraged, and short volatility funds like VXX, TVIX, and XIV are allowed.

There is more variation between brokers on what options transactions are available in your IRA.    I doubt any of them allow selling of naked calls or puts, but I know Fidelity and OptionsXpress support vertical spreads in their IRA accounts, whereas Schwab does not.   Generally long puts and calls, covered calls, and cash secured equity puts are allowed if you are approved at the appropriate option levels.    Cash settled options positions are actually easier to manage since they can’t result in of equity purchases / short sales if the options expire with the underlying’s price between the two strike prices.  In addition cash settled options (e.g., VIX, SPX)  are often have European style exercise, which means they can’t be assigned until expiration.  This is a nice feature for options spreads where you typically don’t want one leg of your spread to turn into a long or short equity position.

Several firms (Fidelity, optionsXpress) offer limited margin accounts in their IRAs to support buying/selling options spreads.  It appears  that Interactive Brokers and TD Ameritrade have IRA margin accounts that can be used to avoid free riding violations, but I have not verified that.  IRA account holders using margin would probably be subject to the pattern day trader rules that require $25K in capital for accounts that trade often on margin, otherwise IRAs should look like cash accounts that aren’t subject to this rule.

The tax treatment of trades in IRAs is pretty simple—in the short term you don’t pay taxes on profits from individual trades, and you won’t be able to take a deduction for any losses.  In a tax deferred account like a traditional IRA you’ll generally pay taxes on your gains when you make distributions, but in the meantime you’re compounding your money without paying taxes, which is a huge advantage.  Of course taxes are a horrendously complicated subject, so consult your tax adviser for definitive answers.

 



Twists and turns in converting a traditional IRA to a Roth

Saturday, November 15th, 2014 | Vance Harwood
 

The change of the tax laws to allow everyone to convert their traditional IRAs into ROTH IRAs in 2010 was a nice present to the tax advisor community.  The issues with this one were nearly enough to make even me, a die hard do-it-yourselfer, seek professional advice.   Instead of paying for advice, I called the IRS.  The woman I talked to in the IRA department was very helpful, seemed very credible–and contradicted some the advice of the people I talked to from Fidelity (800-FIDELITY) and Schwab (800-424-5750).

The key documents I was able to find were IRS form 8606 and its instructions, and publication 590.   My discoveries / conclusions (disclaimers apply):

  1. All the IRAs / SEP / similar accounts (see IRS for specifics) for a individual need to be summed together when considering a conversion.  You can’t convert the account with all post-tax dollars, without accounting for the pre-tax contributions you might have in another account.
  2. Even if you are married, filing jointly, point 1 applies.   You don’t have to combine the husband’s and wife’s accounts together, just all of the accounts of the person that is converting.
  3. Don’t intermingle tax year 2010 contributions in with the conversion.  Some people are claiming there is a loophole that allows 2010 contributions to be converted this year.   The IRS person I talked with said the conversion is intended for 2009 and older contributions–mixing in 2010 contributions looks like a recipe for confusion.   The IRS person suggested that the simplest approach is to zero-out the old accounts by transferring everything (the old accounts don’t need to be closed) before 2010 contributions are made.
  4. The Roth money can’t be pulled out without penalty for 5 years after it is put in–for my case anyway
  5. Both Fidelity and Schwab offer the same capabilities (e.g., option trading level capabilities) in both the traditional and Roth IRA.  Brokers aren’t consistent on this, so be sure to ask if you’re not sure if something is allowed in the IRA account.
  6. Using money from the IRA you are converting to pay taxes due to the conversion seems like a really bad idea.  For starters you will likely have to pay the 10% early withdrawal penalty.

I plan to do a total conversion, a partial conversion looks like a long term headache.

Additional resource:

  • Traditional IRA To  Roth IRA Conversion Tax Example


Trading in IRA accounts, and avoiding “free riding”

Thursday, November 13th, 2014 | Vance Harwood
 

As much as possible I try to trade in my IRA accounts—in order to defer taxes of course. It is a bit counter intuitive to be doing more speculative activities in a retirement account, but this approach supports my goals:

  • Achieving good returns
  • With reasonable risks
  • While compounding growth

If your money is in Roth accounts, all the better, but most people interested in trading in their IRAs are restricted to traditional IRAs.

There are restrictions on what trades you can do in an IRA account.  For example you can’t short a stock in an IRA account, but option restrictions have eased some over the years,  and market innovations like short ETFs (e.g., SH, SDS) have effectively bypassed some of the more onerous restrictions.    Brokers vary considerably in what they allow in IRA accounts, so pays to ask around.   Fidelity for example allows me to do some types of equity option spreads, while Schwab does not.   Covered calls and protective puts on long positions are broadly available within IRAs.  Interactive Brokers and TD Ameritrade both waive the 3 day settlement requirement on trades in IRAs so if you plan to do frequent trades they would definitely be worth a look.

For a more general treatment on trading in IRAs see  “Top 15 Questions About Trading in IRAs.”  The rest of this post will deal with free riding and how to avoid it.

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