The Tax advantages of Trading Options in an IRA

So we've already looked at the questions of Can you trade options in an IRA? (yes) and Should you trade options in an IRA? (yes - as long as you understand options, understand the risks, and have a plan).

Now, in this article, we're going to address a key benefit or advantage of trading options in either a Roth or a Traditional IRA - taxes.

The Disadvantages of Retirement Accounts

As I've explained elsewhere, I'm not saving for retirement (I'm investing for the here and now).

I realize that my position is somewhat controversial, and I'm not trying to persuade anyone to follow my example, but there are some negative aspects to retirement accounts that rarely get discussed.

My chief complaint against retirement accounts is simply that you can't benefit from your investments until you're actually retired.

(I guess that's why they call them retirement accounts after all.)

But as I said in Part 2 of my Why I'm Not Saving for Retirement series, "I don't believe I should have to wait most of my life in order to experience the rewards of building wealth."

And I'm biased, of course, because, as it turned out, I was basically stuck in a job I hated for 6 1/2 out of the 7 years I was there, and I would probably still be in some kind of similar situation if all my personal investing funds were trapped in 401K and IRA accounts.

The transition from gainfully and unhappily employed to self-employment often requires - at least it did in my case - any number of financially creative workarounds.

Tax Advantages of IRAs

OK - enough of the personal history.

Not everyone hates their job (or their boss) or wants to be self-employed, and, of course, you don't even have to be employed in order to open or contribute to an IRA.

And, of course, IRAs contain some very significant tax advantages. So although I've made my own choices, any reasonable person should take a hard look at IRAs and seriously consider them before dismissing them as I have.

Traditional IRAs and Roth IRAs have very different tax structures, although it's not difficult to imagine scenarios where either might make a good choice:

• Contributions to Traditional IRAs lower your current year's taxable income and thus reduce your overall tax burden, although you will be required to pay taxes on your eventual distributions (since you didn't pay taxes on the income that funded your contributions). But for high wage earners, lowering your current taxable income can make a lot of sense, especially if you're on the edge and it brings you down into a lower tax bracket.
• Roth IRAs do nothing to lower your current tax bill (although contributions by low income tax filers can sometimes generate a tax credit), but the big advantage here is that no matter how successful your investments are, retirement distributions are 100% tax free.

No Short Term Taxes on Option Trades

It's important that I point out that I'm not a tax attorney or accountant, nor do I play one on the internet. You are solely responsible for screwing up your own taxes, so everything I say here should be independently verified.

And, everything I'm saying here is from a U.S. tax system perspective (apologies to my Canadian, Asian, and European readers and viewers).

Nevertheless, I will still point out that trading options in an IRA - Traditional or Roth - has one huge advantage over trading options in regular non-retirement accounts - and that's the fact that your option trading gains are not taxed.

With a Traditional IRA, you'll eventually pay taxes on it, but it will all be rolled into your eventual distributions and you'll pay the same rate on all that.

But in a Roth IRA, the advantage is ever more pronounced - you won't pay ANY taxes on your gains. Period.

Under current U.S. tax policy - and as a reminder, the only license I possess is the one that allows me to operate a motor vehicle - your option trading gains in a regular, non-retirement account are taxed at your short term capital gains rate (unless you actually do hold a position, such as a LEAPS option, for longer than one year).

Depending on your income levels, that can be a pretty good sized hit. But in a Roth IRA, your gains aren't taxed at either the short term capital gains rate or the long term capital gains rate. They're taxed at the 0% rate.

Maybe it's a good trade off, and maybe it isn't. Ultimately, only you can decide.

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