How Do I Trade Options in My Roth IRA?
The idea behind Roth IRAs sounds almost too good to be true – pay taxes on contributions now, while your tax bracket may be lower, and avoid taxes on capital gains in the future. There isn’t a catch so much as there are limitations on what a Roth IRA can and cannot do, set by the IRS.
Investopedia set out some of those limitations in its article, “Trading Options in Roth IRAs.” It sets out the boundaries for use of options. It’s important to note that an option, unlike a stock, can lose its entire value if the security price doesn’t make it to the strike price. That risk of total loss puts options in stark contrast to the more traditional investment vehicles used in Roth IRAs.
Options still have their uses in a Roth IRA. They can, for example, provide a way for an investor to hedge against an expected market correction without selling everything into cash, through put options.
However, the IRS did not set out rules for Roth IRAs with the intention that they become a “tax shelter for risky speculation.” According to Investopedia, the most important of these prohibitions for Roth IRAs is that assets in a Roth IRA cannot be used as security for a loan. This disallows margin trading for the contents of a Roth IRA. A more complete list can be found in IRS Publication 590, with what is allowed and what is not set out there.
Financial strategies are not always simple to understand, and connecting their underlying mechanics with their names is not straightforward for an individual who does not work in finance. Simply reading the IRS Publication 590 does not list certain strategies that are still prohibited by implication, such as short combos, call front spreads and other uses of margin.
To further complicate things, not every broker is subject to the same regulations when it comes to options. In order to allow some strategies, a broker may need restricted margin accounts that set limitations on margin sufficient for use with Roth IRAs.
Even if a strategy isn’t built on margin, it might still be against the rules if it includes excessive risk-taking. Options can be a tool used with a Roth IRA – but it’s important to be absolutely certain the strategies used are within the IRS regulations. An experienced investor can help you find strategies that will work best for you and your retirement plans, without running afoul of the IRS.
Reference: Investopedia “Trading Options in Roth IRAs”