In Part 2 of this series, we focus on why an IRA makes an optimum investment vehicle, and why choosing the right IRA Custodian will give the greatest flexibility as you grow your account. Though we are not Certified Financial Planners (CFP), we relay some of the things you may want to consider as you work toward a comfortable retirement. We suggest that you consult with a CFP in your plans, while at the same time take the opportunity to learn how to dramatically grow your own accounts to achieve your goals.
We’re inspired so many of our readers taking advantage of our $7 Platinum trial membership after reading the first article in this series, and congratulate them on taking the next step toward their own retirement financial freedom.
What Kinds of Trades Can I Make in My Retirement Accounts?
Did you know that you can trade in your IRA? A surprising number of people don’t realize that they can trade to increase the money already in their IRAs. And these gains are either tax-deferred or even tax-free. Not only that, those who do trade might be surprised that the tax accounting required to trade may be greatly reduced in an IRA.
Of course, you’ll want to confirm this with a professional tax advisor, but much of the drudgery of trading stocks disappears when you trade within an IRA. That’s because the tax man is really just interested in the money that goes into, and comes out of the IRA. Regardless of how the money appreciates or declines inside the IRA, the tax man just asks that any money taken out of a traditional IRA is treated as ordinary income.
And if you’re lucky or wise enough to have a Roth IRA, those gains are tax free. That’s one of the biggest advantages of a Roth IRA. Remember with a Roth IRA, you invest money into it after you pay taxes on it, while a traditional IRA typically invests pre-tax dollars (though you can also contribute after-tax dollars in a Traditional IRA).
The Traditional IRA’s earnings are tax-deferred, and the Roth IRA’s earnings are tax-exempt.
Imagine knowing how to trade your Roth Investments to make tax-free gains! (Read that sentence again to let it sink in). If you can generate income in your Roth IRA, those gains are tax free*.
Did You Say Tax Free?
Yes, gains are tax-free in a Roth IRA. We’ll tell you more about how you can generate more income in your existing IRAs in just a few moments.
I hope it’s clear to you why it’s helpful to know that IRAs can make great vehicles for investing. Again, we’re not Certified Financial Planners or Tax Advisors, so please confirm any plans you have with professionals who know these areas well, and who keep up with the latest rules and abilities.
Let’s explore some more about trading in your IRAs.
First, let’s talk about what you can and can’t do inside of an IRA. The most important thing to know about an IRA is that there are very strict rules about how money is taken from the account.
For example, with some exceptions, you can’t pull money out before a certain age any time you’d like. Though you may have a very appetizing pile of cash in your IRA, you can’t “quietly” borrow money when you feel like it, with a promise to pay it back.
Rules are in place to qualify for the special tax considerations IRAs offer, created with the intent of keeping the money in the IRA for long-term growth. If you break the rules by making “prohibited transactions”, you risk having your IRA’s classification removed from your account. If that happens, the account will convert into a non-IRA account, and from that point on will act like a bank account. You’ll immediately owe taxes on the untaxed funds in the account, because it’s no longer able to take advantage of the deferred tax handling the IRA offered.
Now there are legitimate allowable ways to pull money out, such as to pay for medical expenses, or purchase a first home. Of course, you won’t want to do this without thinking through it, as the goal is to get that account to grow. Remember that having strategies to grow your account will work even better as your account grows, so leaving it in there is key.
We’re going to focus on what this account was really made for, and that’s for growing your retirement account. And we want it to grow fast. And if we can do it with less tax, the effective buying power increases.
Your Custodian Will Help You
If these IRA “rules” have you a little on edge, it’s understandable. But it’s not something that most people ever worry about, because your IRA custodian has measures in place to protect you.
What is a custodian? The custodian is the company or person who is keeping track of your IRA, and often, holding onto the investment itself. This could be your bank, your broker, or even yourself in some circumstances.
Most have mechanisms in place to prevent you from doing prohibited transactions. It might seem like “red tape” when you’re filling out the forms, etc., but they’re there to protect you.
Therefore, it’s not something you need to worry about. Just follow the simple rules about leaving the money in the IRA. The custodian will help you keep in line as part of their responsibility.
The problem is, though they like holding onto your growing pile of cash, some of those custodians are a bit uneasy about having the IRA responsibility. Therefore, they may impose more rules on your IRA account than is required.
And some of those limiting rules may have no basis in reality at all. Some IRAs may have rules that restrict you from trading in your account. While that may be a rule for that custodian, it’s something that other custodians have no problem doing whatsoever.
That’s why it’s important to shop around to find the right custodian for your IRA. You want one that allows you to trade in your IRA, and be able to trade the markets that you want to trade. For example, you may want to trade futures, or forex, options, and even precious metals or real estate. You can find IRA Custodians that will allow those types of investments, even if other custodians tell you that it can’t be done.
The reason is because there are hard and fast rules for IRAs, and in addition to those there are guidelines. The rules are fairly clear, but the guidelines are open to interpretation. Custodians interpret those guidelines, and even some of the rules themselves, as they see fit. Some are stricter, and some are more lenient. They must all meet the minimum required rules, but what they allow beyond them is up to the company acting as custodian. You may find the larger the institution, the stricter they are, but that’s not always the case.
When you open an IRA at a brokerage, your broker is the custodian. The IRA account you have is kept separate from your other non-IRA trading brokerage accounts. The rules differ between IRA and non-IRA accounts, regarding what and when you can put funds into the account, or take funds out of the account.
You’ll likely find that there are a lot more rules about transactions in IRA accounts, as well as rules about what you can trade in the IRA. This is why withdrawing from a non-IRA account is simple, but when you want to withdraw or add to an IRA account, it takes forms, and signatures, etc.. That is, the red tape.
Forms and rules, it sounds so complex. But in reality, it’s not that bad. Aside from putting money into an IRA or taking money out of an IRA, accounts are quite similar to any other account. Withdrawing from and depositing to an IRA is a relatively rare occurrence. Most people only contribute once a year to their IRAs, and many don’t make withdrawals until they’re in retirement.
Let’s focus more on what we’re allowed to do within an IRA.
Where Selecting the Right Custodian Matters
This is where selecting your custodian matters. As traders, we want as much flexibility in our account as we can get. We want to be in compliance with required rules, but we don’t want to be limited in unnecessary ways by the guidelines of nervous custodians. We want to be able to trade all the markets we want so that we can grow our IRAs as quickly as possible. That IS the goal, right?
So, when preparing to open a new IRA account, find out in advance what types of trading are and aren’t allowed by that custodian. Pay close attention to any limitations they may have in place on IRA accounts.
If you’re an options trader, you probably remember applying for an options “level” authorization. These levels grant you the ability to do certain types of trades. The riskier the trades, the higher the level. It’s relatively easy to qualify for the lower-risk levels, but it gets a little more difficult as you try to gain permission to trade greater risks.
For example, buying and then selling options is relative low risk. Your risk is the value of what you purchase.
Even writing covered calls, which is selling a call option on a stock you already own to generate income, is considered relatively low risk. Since that option is secured by the stock you own, your risk is still limited and contained. That’s because if needed, you could sell the stock to meet the call delivery requirements.
For this reason, most brokerage IRA custodians will allow these types of trades in an IRA. But when it comes time to do more advanced options trades that involve selling options, you’ll likely find that some brokerages will allow it, while others don’t.
Some Will, Some Won’t
Here’s why: It all comes back to the mandatory rules about when you can make deposits or withdrawals in an IRA.
Most people who generate income realize that there’s an annual limit in how much they can contribute to an IRA. Those maximums are set by law, and can vary by the contributor’s age. However, no one can exceed their annual contribution maximum. If you contribute more than that, you will need to remedy that as “excess contributions” as part of your tax filing.
Now let’s review what happens when you do more speculative trading in your account. First, let’s discuss shorting stock, which is something that many IRAs won’t allow. And here’s why.
When you short a stock, you’re actually selling a stock that you don’t own. The idea is that we sell a stock today with the intent of buying it back in the future, and at a lower price. Let’s assume that we’re confident that XYZ will lose value in the next 6 months. If we sell XYZ at $10 per share, and then buy it back in 6 months when it’s only at $7 a share, we can have a $3 gain. We do this by “borrowing” the stock from the broker, with a promise to pay it back. This is called “shorting” a stock. (By the way, going “long” is the term used to buy stock you don’t own, even if we usually don’t hear it referred to that way).
Let’s expand the example. If we sold short 100 shares of XYZ at $10/share, we pocket $1000 today, less commissions (we’ll ignore commissions for these examples). As a result of the short sale, we have $1000 in our account, but we currently own -100 shares of XYZ. And we have to buy that back someday. Let’s say in 6 months, we do buy the 100 shares back at $7/share, for $700. We then get to keep the $300 difference. That’s how shorting a stock works when all goes well.
But what happens if it doesn’t? What if in 6 months we were required to buy back the stock, but it’s now priced at $13? We could have to pay back the $1000 we got to sell it, plus an extra $300. We would lose $300 on the transaction.
What makes this so different than going “long” a stock? (That is, buying and then selling the stock, rather than selling and then buying the stock). Well, if we bought 100 shares of XYZ at $10/share, we must pay $1000, and our account will have +100 shares of XYZ. If in 6 months XYZ is worth only $7 and we have to sell, we’ll only get back $700, losing $300. If in 6 months XYZ rises to $13/share, on selling we profit $300 on top of the $1000 we spent to buy the stock.
As you can see, going long or short a stock is fairly straight forward. Pretty much opposites of the same thing. However, there is one big difference: the risk.
What’s the total risk of buying the 100 shares of XYZ at $10? If the worst-case scenario happens and XYZ loses all its value, the most we can lose is what we paid for it, or $1000.
On the other hand, what’s the risk when we short XYZ. If we must sell XYZ in 6 months and it’s risen to $20/share, then we owe $2000. Since we took in $1000 to sell it 6 months ago, we have to give that back, plus an extra $1000, for a $1000 loss. So far, that sounds about the same as the long case.
But here’s where the difference is. What would happen if XYZ went to $50/share? Now you would have to pay $4,000 more in addition to the $1000 you took in. What if it went to $100/share? That would create a $9,000 loss in your account, even though you only took in $1000 to start with. We’re losing more than we originally took in at the time of the short sale, and perhaps much more.
And what if it went to $500/share? As you can see, the higher the price of XYZ goes, the more you would lose. In fact, the risk is infinite. Theoretically, XYZ could rise indefinitely, and your loss could be infinite. This is why shorting stock can create undefined, or perhaps even infinite risk.
Why doesn’t this happen with the long stock? Because it can’t be worth less than $0. Once you hit $0, it’s all gone, so your risk is defined. For that reason, it’s considered safer than shorting.
So how are people able to short stock in any account, let alone an IRA? The broker requires that you have a margin account, which is effectively a line of credit, that will assure that you have sufficient funds should a short turn against you. And, the broker will also automatically close the position and even other positions you have if it moves against you, hopefully while you still have enough funds and holdings in your account to afford it.
It’s possible when shorting stock that you can lose more than what your account is worth. Let’s say that XYZ was a pharmaceutical company, and you believed that they were on their last leg, ready to go under. And then one of their researchers discover the cure for pancreatic cancer. If XYZ found such a miraculous cure, what would happen to their stock price? It would skyrocket. Anyone with a short in place would then be required to buy back the stock at a much higher price than where they sold it. And if this all happened overnight, there may not be an opportunity to sell as price rises. It might gap higher at the open creating a huge potential cost, even if you have margin, and even if the broker would normally sell it for you before it got too high. It’s very possible that by the time the trades settle, that you owe much more money than the total in your account.
As you can see, it’s a bit messy, and it usually means you must bring more money into your account. That is, you must bring in more capital to make up for that trade’s loss.
And what if you’re trading this in an IRA? If you already made your maximum contribution for the year, you cannot bring any more money into the account. That would be considered an excess contribution, which is not allowed. So not only have you wiped out your IRA account, you can’t bring any new money into the account to make up the additional loss. You can imagine the broker wants nothing to do with that.
This example shows why selling short in an IRA is not allowed. The same rules apply to anything you short in an IRA, including options. Naked calls are pretty much off the table for all IRAs.
The Difference Between Brokers
However, some brokers take this too far. They see “selling an option” of any kind as too risky for an IRA, and that’s where you may find a difference between your broker and another broker. Some, not all brokers, DO allow selling options, as long as the risk is defined. As stated above, many brokers will allow covered call writing, selling an option against stock you own. As long as you have enough shares of the stock to cover your sold call, the risk is limited and in control.
But many brokers don’t recognize another important type of income-producing trade, and that’s spread trading. For example, we may want to sell a “Bullish Put Spread”, which involves selling a put at one price, and then buying a put at the same time at a lower price. Yes, we are selling an option, which by itself would have undefined risk, but we’re also buying an option which puts a limit on that risk. Therefore, the pair together has defined risk.
This is an example of where brokers can differ in their handling of an IRA. Some draw the line and don’t allow spreads, while others do. Since credit spreads are one of the most amazing ways to generate income in an account, we want to make sure that we choose a broker that allows spread trading in an IRA. If the one that you’re using now doesn’t allow it, then perhaps it’s time to shop around.
Rolling.. Rolling.. Rolling…
If you find another broker that does allow spread trading in an IRA, and perhaps other types of trading in an IRA, then perhaps it’s time to switch to them. Don’t worry, you’re not stuck with the one you have just because you have your IRA with them.
You can move your IRA money from one broker to another and still retain your IRA status. This is done through a process called a “rollover”, where you roll over the contents of an IRA into another IRA. The destination IRA could be a new IRA that you create, or it can be an existing IRA that you’ll add to.
There are some rules, of course, that need to be followed, but it’s fairly straightforward and simple to do. You don’t even have to sell your positions in order to make the move. You can move them “in-kind” so you avoid having to liquidate the positions. If you do choose to liquidate and move the money yourself between IRAs, there is a reasonable time limit on how long you can hold onto the cash before you must deposit it into another IRA to keep the IRA status intact.
Now Grow Your IRAs!
And speaking of time limits, remember that our goal is to amass as much wealth as we need by the time we want to retire. IRAs are great vehicles for growing your retirement account and simplifying your tax reporting as you do so, but you also need to get the money to put into the IRA. And you need to have proven strategies that will grow the account, especially when you can’t contribute more than a certain amount each year.
Where are you going to find strategies that can grow your accounts, even in an IRA? At Basecamp Trading, we utilize proven systems to generate daily and long-term income from the markets. This includes stocks, options, futures, and Forex. While we have some specialized approaches that generate wild returns, the majority of our systems are universal, in that they can be applied to multiple markets and time frames. Plus, we provide the education that shows you how the systems work and the concepts behind them. And, we offer live trading rooms, where you can watch our seasoned instructors utilize the same tools they teach, as they “work the systems”. Our approach gives you the foundation to understand, combined with the practicality of real-world trading, to obtain real profits.
In our first article in this series, we stressed the importance of starting early, and that the time to start is now. Every day you wait is costing you, and not just today’s gains, but future gains, as compounding can amplify each day’s gains into more and more growth. Get started now. Please take advantage of our trial offer for just $7, where you’ll get all the benefits of being a platinum member for a full month. You’ll experience first hand just how powerful our systems are, and will begin to understand how the markets have generated the income that many of our students needed to get them on their way to their retirement goals. It’s time to get moving on yours. Click here to get started.
* We are not tax advisors or certified financial planners, so be sure to check with your professional certified tax and financial advisors to determine how the benefits, laws, and opportunities affect your own situation