Roth IRAs must still follow many of the same rules as traditional IRAs, however, including restrictions on withdrawals and limitations on types of securities and trading strategies.
A Roth IRA is a very popular retirement account choice. You pay taxes on the contributions today, and then investors can avoid paying taxes on capital gains in the future. It’s a really smart strategy, if you believe your taxes are likely to be higher after you retire.
In Investopedia’s article, “Trading Options in Roth IRAs,” the use of options in Roth IRAs and some important considerations for investors are examined. Unlike stocks themselves, options can lose their entire value, if the underlying security price doesn’t reach the strike price. This makes them much more risky than the traditional stocks, bonds, or mutual funds that are typically in Roth IRA retirement accounts.
Although risky, there are situations when they might be good for a retirement account. Put options can be used to hedge a long stock position against short-term risks, by locking in the right to sell at a certain price. Covered call option strategies can be used to generate income, if an investor is okay selling her stock.
Many of the riskier strategies in options aren’t permitted in Roth IRAs, because retirement accounts are designed to help individuals save for retirement—not become a tax shelter for risky speculation. Investors should understand these restrictions to avoid issues that could have potentially costly consequences. IRS Publication 590 has several of these prohibited transactions for Roth IRAs. The most important is that funds or assets in a Roth IRA can’t be used as security for a loan. Since it uses account funds or assets as collateral by definition, margin trading usually isn’t allowed in Roth IRAs to comply with the IRS’ tax rules and avoid any penalties.
Roth IRAs also have contribution limits that may prevent the depositing of funds to make up for a margin call, placing more restrictions on the use of margin in these accounts. In addition, the IRS rules imply that many different strategies are off-limits, such as call front spreads, VIX calendar spreads and short combos. These all involve the use of margin.
It’s also important to note that different brokers have different regulations, when it comes to what options trades are permitted in a Roth IRA. The brokers permitting some of these strategies, have restricted margin accounts, where some trades that traditionally require margin are permitted on a limited basis.
The use of these strategies also depends on separate approvals for certain types of options trades, based on their complexity. Therefore, some strategies may be forbidden to an investor regardless. Many of these applications require that traders have knowledge and experience as a pre-requisite to trading options, in order to reduce the likelihood of excessive risk-taking. Roth IRAs aren’t usually made for active trading, but experienced investors can use stock options to hedge portfolios against loss or generate extra income. These strategies can help improve long-term risk-adjusted returns and reduce portfolio churn. You should guard against using options as a mere speculative tool in these accounts, in order to avoid potential issues with the IRS and assuming excessive risks for funds designed to finance retirement.