Your IRA account is special. Follow the rules and you get significant tax consideration from Uncle Sam. At first glance, it may seem like following the rules means sticking to run-of-the-mill investment options. IRAs don't allow traditional margin trading, a requirement for many active trading strategies. There's hope, however – some brokerage firms do allow limited margin-style trading in IRAs.
Traditional margin accounts are basically lines of credit. You put a certain amount of cash and securities into an account, and in return your broker lets you borrow against those assets and buy more securities. You pay interest on this loan, and the loan principal is taken out of your profits. If you run short of your minimum account requirement – your margin – you get a "margin call," a notice to deposit more funds or face consequences.
Benefits of Margin
Other than the obvious benefit of spending money you wouldn't otherwise have, margin accounts let you trade faster than normal cash accounts. Most trades take three days to settle: you make agreement to swap cash for securities on the trade date, but the swap isn't executed until three business days later. You can't use that cash until it's in your account, so you have to wait. For an active trader, this may mean three days worth of missed opportunities. In addition, some options and futures transactions can only be completed in margin-style accounts to comply with federal regulations.
IRAs and Margin
The big barrier to margin trading in an IRA is the IRS' "no loan" policy. To comply with IRA rules, you cannot use your IRA assets as collateral, and this is exactly what you need for a traditional margin account. You can't use an IRA account as a line of credit, as you would with a traditional account. Many brokerage firms do allow limited margin accounts for IRAs. These accounts allow you to trade on unsettled funds – the money that's sitting in limbo between trade date and settlement date. They also meet the regulatory requirements for more options and futures transactions.
You cannot short stock in a margin IRA and you cannot sell uncovered calls. Certain activities, such as a short call or put, place restrictions on your account to prevent you from selling the underlying security or running short on cash. Finally, most brokerage firms hold account owners to federal day trading restrictions by requiring a minimum account value of at least $25,000. They may also require a certain level of trading experience prior to opening the account.
There is no fun in the investment world without risk, and margin IRAs have high risks. If you at any time have an IRA account balance of zero, or if there is any type of loan activity in your account, your IRA is immediately disqualified from preferential tax treatment. This means that the full balance of your IRA is considered distributed and subject to a slew of taxes and penalties.
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.