In the U.S., 24.9 million households have Roth Individual retirement accounts accounting for over $1 trillion in retirement assets in 2019 according to the Investment Company Institute. Roth IRAs are retirement savings vehicles that are funded with the after-tax dollars that make distributions that provide tax-free investing. Roth IRA rules are developed by the IRS to help protect the savings. Further, the rules regarding the taxation of contribution and withdrawals that limit how much you can contribute in a given year.
Day-trading profits can be slashed by capital gains taxes and trading fees. Tax-protected accounts – specifically Roth IRAs – are extremely appealing, as these accounts allow capital gains and other income to grow in the account tax-free. As an added benefit, the income in a Roth account may also be withdrawn without additional taxes if tax rules are observed. But while day trading is not prohibited within Roth IRAs, regulations make traditional day trading virtually impossible.
Day Trading Defined
Day trading is defined by the Financial Industry Regulatory Authority, or FINRA, as the purchase and sale of the same security on the same day. Stock and bond trades have a three-day settlement period, meaning that there is a time lag between the agreement to purchase shares and the time when you receive shares in your account and are required to pay for them. (The reverse is true for a sale.)
When you perform basic day trades, you count on your ability to cover your purchases with the money you receive from your sales, as well as the ability to deliver shares you do not have in your possession on the day you sell them (also known as short selling). Day trading is characterized by technical analysis and a high degree of objectivity and discipline.
In simple terms, day trading is defined as the practice of buying and selling a security within a single trading day. It is part of a number of investment strategies that individuals can utilize to earn a return from their investment.
Margin Accounts Rules
FINRA regulations require pattern day traders to use margin accounts. A pattern day trader executes four or more day trades within five business days. Margin accounts use assets within the portfolio as collateral on a loan of cash from the broker. These loans kick in as needed, whether to cover a trading mishap or to provide additional buying power for the trader.
Pattern day traders are required to keep a minimum of $25,000 in collateral in their accounts at all times and at least 25 percent of total trading value when trades are active. Roth IRA rules prohibit many risker strategies associated with day trading since retirement accounts are designed as a way to save for retirement. As such, they cannot be used as tax shelters for risky speculation. Investors are aware of the restrictions in order to avoid running into legal problems that can have devastating consequences.
The majority of the day trading brokers utilize margin trading which is not allowed in Roth IRA accounts. IRA owners participating in prohibited transactions will lose the tax-protected status of their accounts and become immediately liable for taxes and penalties for the full value of the IRA. Further, Roth IRA rules have contribution limits that prohibit the depositing of funds to the account to cover losses or in case of a margin call. The rule exposes a Roth account to a loss to the entire account in case the transaction turns out negative.
Day Trading Considerations
Most brokerage firms will prohibit short sales outside of margin accounts, meaning that you cannot sell something you do not already own. However, it is possible to sell an asset and then repurchase it in the same day without running into rule violations, provided there is cash in the account to cover the purchase and you do not complete such a transaction more than four times within a five-day period. Day trading relies on the ability to make fast trading turn-arounds, however, so any restriction negatively effects the final profit in the account.
Roth IRA rules are interpreted differently as brokers seek to introduce investment strategies within the rules. For example, Fidelity permits the trading of vertical spreads in a Roth account with a condition that $2,000 being set aside as a reserve. The use of the investment strategies is dependent on separate approvals of the certain types of options trades depending on the complexity. Roth account investments should be wise in adopting those strategies even they were permitted since they are clearly toward the speculation other than savings.
Active Trading vs. Day Trading
Roth IRA owners looking to take full advantage of tax-free earnings may find more benefit in taking an active trading approach to their retirement savings. Active trading involves a similar market timing technique to day trading, but takes the timing period to days or weeks rather than minutes and hours. This type of trading increases the potential for rapid account growth while decreasing the risks of trading on margin. Research has consistently shown that passive income beats active trading on the Roth IRA account.
For example, a 2018 study from the S&P Dow Jones Indices revealed that 63 percent of the fund managers who invested in the large companies in American underperformed compared to the previous year. The deficit increased over time, and over a 5-year period, 92 percent of the professional traders failed to beat the benchmark. Investors who sticking the passive approach earned returns by hiding on to investments over many years.
Some investors may be concerned as they actively trade in the Roth IRA. However, there is no explicit prohibition in the Roth IRA rules. However, day-trading is limited to certain brokers and the extra fees if they trade certain kinds of investments. Tax-free investing is a priority to every individual and investing in Roth IRA is popular as investors avoid capital gains and dividends. However, to earn the benefits, you must abide by the Roth IRA rules.
Day Trade Warning
A Roth IRA account's purpose is to fund your retirement rather than speculating investments and any decision undertaken on the account must be a risk-free investment to save the funds for the future. Day trading, margin trading, and active trading all involve a significant amount of risk.
Smart investors should take time to educate themselves on all aspects of these trading processes and should never invest money they cannot afford to lose. Though Roth IRAs are not designed for day-trading or active trading, experienced investors can use the stock options and hedge portfolios against loss while generating extra income.
Such strategies can help improve long-term risk-adjusted returns. Before making a decision to day-trade in their Roth IRA, it is prudent to carefully consider the costs and potential benefits. It is always tough to beat the market and you will spend a huge amount of time doing so. A simple buy-and-hold strategy is a proper strategy that is not hectic like the day-trading and provides risk-free investing for a Roth IRA account.
Nola Moore is a writer and editor based in Los Angeles, Calif. She has more than 20 years of experience working in and writing about finance and small business. She has a Bachelor of Science in retail merchandising. Her clients include The Motley Fool, Proctor and Gamble and NYSE Euronext.