Trader Taxation – Part 3 – Trading One’s Individual Retirement Account

• IRON100
• January 22nd, 2010

This third post on taxes for trading businesses will be a thumbnail sketch of what happens when one trades one’s own retirement accounts and what happens when they become quite large (which I hope yours will become, as the trading portion of mine is becoming now). Most of this information is coming from “The Tax Guide for Traders” by Robert A. Green, CPA. This book breaks down in a fairly comprehensive but easily understood way how to avoid problems with establishing trading businesses.

I will make it thumbnail because:

1) There are many layers of complexity for those who either manage money for small groups of people, which automatically impinge upon individual state laws regarding de minimis rules under Uniform Securities Laws of individual states and FINRA requirements. De mimimis rules determine how many individuals' accounts one may manage to license oneself as a registered investment adviser under United States law.

2) Each state has rules with regard to point one. Each state has its idiosyncrasies with regard to that number. For example, if I go above managing five individual accounts for others in South Carolina, I must register. In other states, that number can vary widely.

3)  One of the reasons I decided to manage only my own money is that I like to keep my tax structures simple. I do not do that out of fear of the IRS, I do it because it makes the rules of operation, for the most part, easy to understand and easy to defend to the IRS. Anything that limits the regulatory hassle of what you deal with will make your business easier to manage.

There are two other accounts that I will not address at this time:

1) One is the 401-Ks plans for traders who meet the trading business requirements. One reason is simple. I think Congress is eventually going to re-characterize 401-Ks into instruments that mimic Social Security benefits. I will keep you updated as I see more information, but for now I think one should tread lightly in that arena. The other is the complexity of dealing with multiple employees’ plans that might be working within that business. One needs to understand the benefit structure in precise language. If I do that, this post would become a book, and could itself be subject to independent interpretation by the IRS.

The benefits of Roth IRAs, if allowed to grow over time, are quite tremendous, as contributions are taxed, but withdrawals during retirement are not. 

The major benefit of 401-Ks for business traders, however, is the elective deferral of revenue and a maximum defined contribution profit-sharing plan in one boat, which can save money and can increase one’s Social Security benefits over time as well.  If the 401-Ks become accounts that just barely keep pace with inflation, the benefits of a Roth IRA will be even that much better. 

Once I understand what the status on 401-K re-characterization legislation is before Congress, I will pass it along to you. For now, I will stick with the Traditional IRA and Roth IRA discussion.

2) Another tax-deferred account on which I will also delay discussion to another time is the Health Savings Account. Depending upon how one sets it up, it either can or cannot be traded. Rules are changing on these accounts, however, as they can become self-directed just like Individual Retirement Accounts.

Trading Traditional and Roth IRA Accounts:

These accounts offer incredible tax-deferred or tax-free benefits to traders as long as:

1)      They keep their costs low (that is use direct access brokerage accounts).

2)      They have a profitable trading system that can be applied to the accounts

3)      They are simple one employee (one-individual) trading accounts.

The first two are obvious right?  If one can get as close to direct access brokerage as possible (and I use exclusively direct access brokerage), then commission costs are negligible compared to net profits, assuming the system is profitable.

The third part is where trouble can occur. Why, do you ask? If one’s IRA is part of a multi-employee IRA arrangement, it is covered under the Employee Retirement Income Security Act (ERISA) of 1974. These plans require a fiduciary to manage risk and diversify assets in the plans.  Although there is not much case law to back it up, one probably needs to consult a tax professional (CPA or tax attorney in all likelihood) to make sure one can trade an account. If the IRAs are set up as individual plans (as opposed to employee group plans), then one should be free to trade the plan as frequently as one wishes. 

There are other things one cannot do with a retirement account or one will face the wrath of the IRS:

1)  If one’s taxable business is a money management firm one may NOT be a partner to one’s trading entity (that is those funds cannot be comingled into those taxable assets).

2)  One cannot sell taxable investments from a taxable account to an IRA. (That is called self-dealing and that is prohibited in the United States Tax Code).

3)  Neither the fund manager nor members of that manager's family may invest their IRA funds into the manager's hedge fund or taxable managed assets.

4)  The IRA may also not create revenue for the taxable fund manager (in terms of income or fees). The IRA may not help pay expenses for the fund manager’s taxable fund either.

Summary:

I am going to stop there for now, but the key thing is, if one trades one's Individual Retirement Account and it is not ERISA limited, it can be traded as frequently as one likes and commissions and fees can be limited. Also remember that the pattern day-trade rules apply for these accounts, so if one trades more than the minimum number in that rule, one must have $25,000 in assets to pattern day-trade.

Would I trade every nickel of my retirement funds in such a manner? The answer for me is NO, but that, once again, is up to you and your risk tolerance. You first must understand how to trade properly and profitably and to limit expenses before making a substantial effort to trade one’s retirement funds, but it can be done. It is never a great idea to put all your eggs in one basket. A little risk diversification among risky assets will help one participate in a variety of markets when one market is slow.

What I would like readers to do after reading this is to post questions so that I may adequately answer them. Even if I cannot answer it directly, I believe I can point you in the right direction in terms of getting it answered. This entire topic was the result of a reader request, and I will so all I can to service those requests.

Also, I would still ask that others who wish to contribute to DieBrokeBlog from the StockTwits community to contact me at buffalotrader100@gmail.com . There are too many smart people in this community not to have independent contributions to arise from the ranks.  We really appreciate your participation and reading of this blog so far.

Tickers: 401-K, de minimis provisions, direct access brokerage, Employee Retirement Income Security Act of 1974, ERISA, Health Savings Account, Individual Retirement Accounts, Roth IRAs, Traditional IRAs

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