Roth individual retirement accounts (IRAs) have become extremely popular over the past several years. By paying taxes on their contributions today, investors can avoid paying taxes on capital gains in the future—a good move if they think their taxes are likely to be higher after they retire.
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. Below, we’ll take a look at the use of options in Roth IRAs and some important considerations for investors to keep in mind.
Why Use Options?
The first question that investors might be asking themselves is why would anyone want to use options in a retirement account? Unlike stocks themselves, options can lose their entire value if the underlying security price doesn’t reach the strike price. These dynamics make them significantly riskier than the traditional stocks, bonds, or mutual funds that typically appear in Roth IRA retirement accounts.
While it’s true that options can be a risky investment, there are many instances in which they might be appropriate 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, while covered call option strategies can be used to generate income if an investor doesn’t mind having to sell their stock.
For example, suppose that a retirement investor holds a long portfolio consisting of low-cost Standard & Poor's 500 index funds. The investor may believe that the economy is due for a correction, but might be hesitant to sell everything and move into cash. A better alternative might be to hedge the S&P 500 exposure with put options, which provide a guaranteed price floor for a certain period of time.
Many of the riskier strategies associated with options aren’t permitted in Roth IRAs. After all, retirement accounts are designed to help individuals save for retirement rather than become a tax shelter for risky speculation. Investors should be aware of these restrictions in order to avoid running into any problems that could have potentially costly consequences.
IRS Publication 590 contains a number of these prohibited transactions for Roth IRAs. The most important of them indicates that funds or assets in a Roth IRA may not be used as security for a loan. Since it uses account funds or assets as collateral by definition, margin trading is usually not permitted in Roth IRAs in order 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, which places further restrictions on the use of margin in these retirement accounts. These contribution limits change each year. The annual limits for 2020 and 2021 are $6,000 for people under 50 and $7,000 for those 50 or older, according to the IRS. These limits do not apply to rollover contributions or qualified reservist repayments.
Interpreting the Rules
These IRS rules imply that many different strategies are off-limits. For instance, call front spreads, VIX calendar spreads, and short combos are not eligible trades in Roth IRAs because they all involve the use of margin. Retirement investors would be wise to avoid these strategies even if they were permitted, in any case, since they are clearly geared toward speculation rather than saving.
Different brokers have different regulations when it comes to what options trades are permitted in a Roth IRA. Fidelity Investments permits the trading of vertical spreads in IRA accounts with only $2,000 set aside as a reserve. Charles Schwab Corp. (SCHW) requires a balance of at least $25,000 for spread trading. The brokers permitting some of these strategies have restricted margin accounts whereby some trades that traditionally require margin are permitted on a very limited basis.
The use of these strategies is also dependent on separate approvals for certain types of options trades, depending on their complexity, which means that some strategies may be off-limits 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.
The Bottom Line
While Roth IRAs aren’t usually designed for active trading, 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 while reducing portfolio churn. Safeguards should be taken so that the options do not seem like a mere speculative tool in these accounts, in order to avoid potential problems with the IRS’ rules and taking on excessive risks for funds slated to finance retirement.