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 As an added benefit, the income in a Roth account may also be withdrawn without additional taxes if tax rules are observed.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).
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 Prohibited Transactions
The Internal Revenue Service prohibits the use of IRA assets as collateral. This means that Roth IRA accounts cannot be margin 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.
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.
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.
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.
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.