This is the second part in our series of How to Trade Stock Derivatives in a Solo 401k. Click here for Part 1 (How to Trade Stocks in Your Solo 401k).
There are many moving parts when trading stock derivatives in an IRA or Solo 401k. The IRS and tax code do not specifically forbid any of these trades. However, you need to look deeper into the rules involving borrowed money (margin accounts) and Unrelated Business Income Tax (UBIT).
There are also significant differences in the rules that apply to an IRA compared to a Solo 401k. For instance, IRAs are not allowed to borrow money for any reason but a Solo 401k can borrow as long as it is a non-recourse loan. Keep those key concepts in mind as you determine what you are and are not comfortable doing with advanced security trades.
Trading Stock Derivatives in Your Solo 401k
Notably, the IRS does not always have the final say in what you can and cannot do with your self directed retirement funds. The brokerage firm where you establish your trading account might have their own rules. Sometimes, those rules are stricter than IRS rules. For instance, the IRS allows you to borrow up to 50% of the purchase price. However, the brokerage firm might only allow a lesser amount (say 30%). The brokerage firm may also have other policies that are different and/or more restrictive than IRS rules.
First, determine if the IRS allows your transaction. Then, determine the trade is allowed by your brokerage firm. A Solo 401k will have more flexibility than an IRA. Again, account for UBIT even with your Solo 401K.
With that said, if you want to make advanced security trades in your IRA or 401k, look for the term “self directed”. Self-directed accounts allow you to take complete control of your investment choices. They also typically allow futures, futures options, and other advanced trade types. Be sure you know the difference between opening a 401k with the brokerage firm (usually not full self-directed) or having your Solo 401k account open a brokerage account in the name of your Solo 401k. The latter gives you the most control and flexibility.
Basics When Investing in Advanced Securities With a Solo 401k/IRA
Typically, self directed retirement accounts with a custodian prohibit the use of any type of derivative trading inside their accounts, except for covered call writing. A covered call is the type of stock trade people are most familiar with. One investor has full ownership of a stock and sells it to another investor for cash. Any IRA or 401k can make these trades.
What’s important here is that Nabers Group is a non-custodial document provider for your self directed retirement account. Therefore, we do not prohibit any type of derivative trading inside your accounts. However, we do not recommend or qualify your transactions. Nabers Group is not your compliance officer. We strongly recommend you work with your CPA and/or tax advisor to ensure your deals pass muster. If you don’t have a CPA able to assist you, we can provide a list of CPAs familiar with the Solo 401k.
Can I trade options in my Solo 401k? The short answer is YES. The real question is will it trigger the UBIT rules. Buying an option itself will not trigger UBIT. This is because an option gives the buyer the right, but not the obligation to buy or sell the asset at a specific price on or before a certain date. If the option expires without execution, UBIT will not apply. However, UBIT rules would likely apply if the options were held by a business/organization/trust as inventory or for sale to customers as part of ordinary business (an exception that does not apply to most investors).
Futures and Shorting Stocks
Can I buy futures in my Solo 401k? Futures are not significantly different from stocks. Futures trading involves buying and selling contracts for what the price will be in the future. This might include markets such as agricultural commodities, foreign currency, metals, and other items where the price fluctuates from day-to-day. Because your Solo 401k gives you complete control of your investment choices, it does allow futures and futures options trading.
Can I short stocks in my Solo 401k? It’s possible, but there are many obstacles (not specifically imposed by Nabers Group). Theoretically, the problem is that short sales have unlimited risk. Shorting stocks involves borrowing the shares and then selling for cash only to buy back the same number of shares right before returning them to the lender. If the stock goes down in the interim, the investor pockets the difference. However, the profit on a margin account may trigger UBIT.
On the other hand, the unlimited risk is based on the fact that the cost to buy them back could go up an unlimited amount. There is no limit to how much it could cost you to buy back the shares to return them to the lender. For that reason, most brokers will not allow retirement accounts to short sell. Also, there is some indication the IRS wants to prohibit short sales because of the unlimited risk.
Stock Derivatives: Uncovered Calls and LEAPs
Can I do uncovered calls in my Solo 401k? Uncovered calls are also known as “naked calls.” This is another high-risk strategy because of the possibility that the account could go into negative territory and need money to cover the call (that it does not have). It is especially risky for 401k and IRA accounts because of contribution limits that might prevent you from paying the amount owed. You cannot personally guarantee an uncovered call with non-retirement funds. No broker wants to be in the position where you could owe money but not be able to repay it. Remember, your Solo 401k is completely separate from your personal finances, so you can’t personally repay the money. It’s a similar situation to shorting stocks.
Can I buy LEAPS in my Solo 401k? Long-Term Equity Anticipation Securities (LEAPS) are options with expiration dates ranging from nine months to three years into the future. Because these are options without owning the security, give the same consideration to UBIT rules. LEAPS are the same as the options already discussed. Therefore, the only real difference is the length of time you hold the LEAPS. LEAPS can even be for an almost unlimited amount of time. Accomplish this by selling one LEAP position about to expire. Then, purchase a replacement LEAP with an expiration date further into the future. Because of the long lengths of time, these can sometimes be highly profitable.
Example of Trading Stock Derivative as a Hedge
You can invest in derivatives based on almost anything. Derivative markets include the weather that determines the rain and sunshine affecting farm crops in a particular region of the globe. Because almost anything can have a derivative market, these assets should be considered high risk. But you can also use this strategy to hedge other investments. This might include buying stock in a foreign market that is not based on U.S. dollars (USD).
For example, an American investor can purchase shares in a European company on a stock exchange using euros (EUR). The entire time the investor holds the shares, (s)he is exposed to price changes of the shares as well as the monetary exchange rate. The monetary exchange risk is that value of the USD will increase in relation to the EUR. If this happens, any profits the investor earns by selling the stock become less valuable when they are converted into USD.
The investor can protect his investment for the cost of purchasing a currency derivative option to lock in a specific exchange rate. These common derivatives are called currency futures and currency swaps.
This derivative does not have to be tied to the stocks that he/she purchased. The derivative could even make the investment more valuable than just the increase in the stock price. However, can you limit your downside. If the exchange rate goes in the opposite direction of the derivative, the investor simply does not exercise the derivative option. All Solo 401k loses is the original cost of the option.
Work with Experts
Again, Nabers Group is a non-custodial document provider for your self directed retirement account. Therefore, we do not prohibit the use of any type of derivative trading inside your accounts. But, we also don’t qualify or recommend any investment structure or strategy. We strongly recommend you work with your CPA and/or tax advisor to ensure your deals pass muster.
A Solo 401k is the one account that puts you in full control of when, where, and how you want to invest.