The Roth Individual Retirement Account (IRA) has become very popular in the past few years. By taxing their contributions today, investors can avoid taxing capital gains in the future-a good move if they think their taxes may be higher after retirement.
However, Roth IRAs must still follow many of the same rules as traditional IRAs, including restrictions on withdrawals and restrictions on types of securities and trading strategies. Below, we will look at the use of options in the Roth IRA and some important considerations that investors need to keep in mind.
Why use options?
The first question investors might ask themselves is, why would anyone want to use options in a retirement account? Unlike the stock itself, if the price of the underlying security does not reach the strike price, the option may lose its full value. These dynamics make them much riskier than traditional stocks, bonds or mutual funds that usually appear in Roth IRA retirement accounts.
Although options are indeed a risky investment, in many cases they may apply to retirement accounts. Put options can hedge long stock positions by locking in the right to sell at a specific price, and if investors don’t mind selling their stocks, they can use a guaranteed call option strategy to generate income stocks.
For example, suppose a retired investor holds a long portfolio of low-cost S&P 500 index funds. Investors may think that the economy is about to adjust, but may hesitate to sell all commodities and convert them to cash. A better option may be to use put options to hedge the exposure of the S&P 500 Index, which provides a guaranteed price floor for a certain period of time.
The Roth IRA does not allow many riskier strategies associated with options. After all, retirement accounts are designed to help individuals save for retirement, not to be a tax haven for risky speculation. Investors should be aware of these restrictions to avoid any problems that may have potentially costly consequences.
IRS Publication No. 590 contains many transactions that are prohibited by the Roth IRA. The most important one indicates that the funds or assets in the Roth IRA cannot be used as loan guarantees. Since it uses account funds or assets as collateral by definition, Roth IRA generally does not allow margin trading to comply with IRS tax rules and avoid any penalties.
The Roth IRA also has contribution restrictions, which may prevent deposits to make up for margin calls, which further restricts the use of margin in these retirement accounts. These contribution limits change every year.
The annual limits for 2021 and 2022 are US$6,000 for people under 50 and US$7,000 for people over 50. These restrictions do not apply to renewal contributions or repayment of qualified reserve personnel.
These IRS rules mean that many different policies are prohibited. For example, call option spreads, VIX calendar spreads, and short combinations are not eligible for trading in the Roth IRA because they all involve the use of margin. In any case, it is best for retired investors to avoid these strategies, even if they are allowed, because they are clearly for speculation rather than savings.
Different brokers have different rules regarding which option transactions are allowed in Roth IRA. Fidelity Investments allows vertical spreads to be traded in an IRA account, leaving only $2,000 as a reserve.
Charles Schwab Corp. (SCHW) requires that the balance of the spread transaction be at least 25,000 USD. Brokers that allow some of these strategies restrict margin accounts, allowing some transactions that traditionally require margin on a very limited basis.
The use of these strategies also depends on the separate approval of certain types of option transactions, depending on their complexity, which means that in any case, certain strategies may be a forbidden zone for investors. Many of these applications require traders to have knowledge and experience as a prerequisite for trading options to reduce the possibility of excessive risk-taking.
Although Roth IRAs are usually not designed for active trading, experienced investors can use stock options to hedge portfolio losses or generate additional income. These strategies can help increase long-term risk-adjusted returns while reducing portfolio loss.
Protective measures should be taken to make these options appear to be more than just a speculative tool in these accounts to avoid potential problems with IRS rules and excessive risk for funds that plan to fund retirement.