It is possible to trade penny stocks through an individual retirement account (IRA); however, penny stocks are generally quite risky, so making this investment choice should be done with caution.
The term penny stock is a rather subjective one because what constitutes a penny stock is dependent upon which individual a person asks. In a basic sense, a penny stock trades at a relatively low share price and represents equity shares in a company with relatively low market capitalization. For some, a penny stock is literally one that trades for pennies, or less than $1. To others, a penny stock is any stock that trades for under $5. One other commonly used definition of penny stocks is a stock traded outside a major market exchange such as the NYSE or the Nasdaq.
Penny stocks are considered one of the riskiest and most speculative equity investments. Contributing to their high-risk classification is the fact penny stocks often suffer from a severe lack of liquidity, which translates into very unfavorable bid-ask spreads. Penny stocks are subject to far fewer listing requirements and regulatory standards, and it is often difficult to obtain sufficient reliable information on penny stock firms to enable an investor to adequately evaluate companies for investment purposes.
IRA Investing in Penny Stocks
There are IRAs that may invest in penny stocks. In these instances, an individual most likely works with a broker-dealer that permits its clients’ IRAs to invest in stocks traded on the over-the-counter bulletin board (OTCBB). Besides the OTCBB, penny stocks are also traded through pink sheets.
There are a number of brokerage firms with IRA brokerage accounts that enable investments in penny stocks. Among some of the most popular of these firms are E-Trade, TD Ameritrade and Scottrade. Though a self-directed custodian IRA can be used to purchase penny stocks, it is generally considered more advisable to utilize brokerage IRAs to facilitate penny stock trading. Low transaction fees are a must for penny stock investors and should be considered when selecting a broker. (For related reading, see "Why It's Hard to Find a Custodian for a Self-Directed IRA.")
Although penny stocks are relatively cheap, they come with substantial risks. Investors considering penny stock trading should decide whether it truly falls within their risk tolerance level and whether it is a proper use of their IRA 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 his due diligence and be certain it is a proper investment strategy.
(For related reading, see "4 Signs a Penny Stock Is Worth Millions.")