It is possible to buy a penny stock inside an individual retirement account (IRA). Outside of life insurance and collectibles such as artwork and coins, the Internal Revenue Service (IRS) places few limitations on the types of assets an IRA may hold. However, penny stocks are generally quite risky, so making this investment choice should be done with caution.
The term penny stock is subjective. The Securities and Exchange Commission (SEC) refers to penny stocks as securities issued by companies with low market capitalizations. These stocks are generally (though not always) traded over-the-counter such as on the Over-The-Counter Bulletin Board (OTCBB).
For some, a penny stock is literally one that trades for pennies, i.e. less than $1. To others, a penny stock is any stock that trades for under $5. Some view penny stocks as any security traded outside a major exchange such as the New York Stock Exchange (NYSE) or the Nasdaq.
Penny stocks are considered risky and speculative. They often suffer from a lack of liquidity, which translates into wide bid-ask spreads. In other words, the lack of liquidity means that it can be difficult to buy and sell since there might not be any market participants willing to trade the stock at that time. As a result, a wider spread gets built into the buy and sell (or bid and ask) prices from the broker. Also, penny stocks are subject to fewer listing and regulatory requirements. It is often difficult to obtain reliable information on penny stock companies to adequately evaluate them.
IRA Investing in Penny Stocks
Some IRAs allow you to invest in penny stocks. In these instances, an individual most likely works with an IRA trustee that permits client funds to be invested in stocks traded on the OTCBB or Pink Sheets.
There are a number of brokers with IRA accounts that enable investments in penny stocks. Among some of the most popular are E-Trade and TD Ameritrade. Although a self-directed IRA can be used to purchase penny stocks, it is generally considered more advisable to utilize brokerage IRAs. Low transaction fees are a must for penny stock investors and should be considered when selecting a broker.
Although penny stocks seem nominally cheap, they come with substantial risks. Investors should decide whether penny stocks truly fall within their risk tolerance and whether it is a proper use of retirement funds. One risk-reduction option before trading a penny stock is to find out from the broker if the stock is DTCC eligible.
The Depository Trust and Clearing Corporation (DTCC) is responsible for the clearing of securities for brokerages. If a stock has some type of restriction or is otherwise not DTCC-eligible, this usually indicates it will be extremely difficult for an investor to sell the stock's shares after purchasing them. Lack of DTCC eligibility also typically means substantially higher trading fees for purchasing or selling a stock.
Any individual considering the use of an IRA account for penny stock trading must do due diligence and be certain it is a proper investment strategy.