I was researching brokers that let us use options in your IRAs and came across the following very interesting white paper prepared by CBOE, discussing in part the tax rules regarding options in IRAs. I have copied the tax related part below. The complete article can be viewed at
cboe.com
Overview of Legal and Accounting Issues
A. IRAs
IRAs consist of assets that were either contributed to the IRA by the individual,18 or distributed from an employer-sponsored retirement plan.19 IRAs take two forms: "trusteed" or "custodial." Trusteed IRAs have a trustee, such as a bank, which holds the assets. Many IRAs with trustees permit the trustee to manage and invest the assets of the IRA. Other trusteed IRAs permit the IRA owner to direct how the trustee will invest the IRA assets. In either case, the trustee will be subject to certain fiduciary responsibility rules of the state in which the IRA trustee is located.20
The other type of IRA is a custodial account. Most brokerage firms, as well as many other financial institutions, offer self-directed custodial IRAs. Since there is no trustee of the account, the owner is fully responsible for investment decisions, and state law fiduciary liabilities do not arise from the management of the account.21
B. Keogh Plans Covering Employees
Keogh Plans also consist of assets that were either contributed to the Plan by the individual, or distributed from an employer-sponsored retirement plan. However, Keogh Plans are subject to considerably higher contribution limits that apply generally to employer-sponsored retirement plans.22 Keogh plans that cover employees as well as owners are subject to the fiduciary responsibility rules of the Employee Retirement Income Security Act of 1974 ("ERISA").23
ERISA imposes on the individuals responsible for investing retirement plan assets the obligation to carry out investments prudently and in the exclusive interest of plan participants.24 The Department of Labor has informally indicated that the use of derivatives, including exchange-listed options, in retirement plan investments may be appropriate, but generally requires a higher level of expertise and analysis than more traditional investments.25
The Department of Labor has issued regulations that permit fiduciary liability exposure to be greatly reduced in plans where investments are self-directed by participants.26 However, due to limitations on this protection and the complexity of the rules, this approach is seldom taken as an avenue to permit options trading. As a result, while options are used in the investment strategies of plans subject to ERISA, they tend to be limited to the most conservative approaches such as the sale of covered call options.
C. Keogh Plans Covering Only Owners
Keogh Plans that do not cover any employees (in other words, cover only the owners) are not subject to ERISA and its fiduciary standards. 27 Trusteed Keogh plans, like trusteed IRAs, are subject to state trust laws. However, Keogh Plans that cover only owners may use a custodial account instead of a trust and, therefore, state trust laws would not apply.
D. Tax Considerations
1. General Tax Rules
Gains and other income generated within an IRA or Keogh Plan are generally not taxable. By the same token, losses are not tax deductible. The owner or beneficiary is taxed at ordinary income tax rates as the assets of the account or plan are distributed. In general, withdrawals before the owner or beneficiary reaches age 59-1/2 are also subject to a 10% excise tax penalty. Distributions must begin by age 70-1/2 or excise tax penalties will apply.
A new type of IRA, called the "Roth IRA" is first available in 1998. Like a traditional IRA, profits and losses in a Roth IRA are not taxable. However, unlike a traditional IRA, contributions to a Roth IRA are not deductible, while distributions from Roth IRAs are not taxable. In addition, Roth IRAs are not subject to the rule that requires distribution to begin at age 70-1/2. Amounts from other IRAs and qualified plans can be transferred to a Roth IRA, but this results in tax on the amounts transferred. Annual contributions to Roth IRAs are limited to the amounts that could be contributed to a traditional IRA and deducted. An individual's ability to make contributions to a Roth IRA or to convert a traditional IRA into a Roth IRA is not allowed if the individual's adjusted gross income exceeds certain limits.
Another new type of IRA, called an "educational IRA," is first available in 1998. As long as a person's modified annual adjusted gross income does not exceed $150,000 for joint filers ($95,000 for single filers), the individual may make a non-deductible contribution of up to $500 per child per year to an educational IRA. Earnings on contributions will be distributed tax free, if they are used to pay the beneficiary's post-secondary education expenses.
Certain small businesses may establish a so-called "SIMPLE IRA." An employee participating in a SIMPLE IRA may make an elective contribution of up to $6,000 per year to the IRA, which may be matched by the employer for a maximum contribution of $12,000 on behalf of the employee to the SIMPLE IRA. The contributions are excludable from the employee's taxable income. Like traditional IRAs, distributions from a SIMPLE IRA will be taxable.
2. Prohibited Transaction Rules
IRAs and Keogh Plans are subject to prohibited transaction rules contained in the Internal Revenue Code, which also apply to other qualified retirement plans.28 These rules generally prohibit an owner or beneficiary from using the assets of the account or plan for any purpose other than investment for the benefit of the owner or beneficiary. (For example, the assets cannot be borrowed by the owner or invested with the owner's company.) Likewise, transactions between the account or plan and a "disqualified person"29 (including the owner/beneficiary, owner's/beneficiary's family, and other related parties) may result in tax penalties and potential loss of special tax status of the account or plan.30
The purchase and sale of options in the open market are not prohibited transactions. However, Internal Revenue Code prohibited transaction rules prohibit the IRA or Keogh Plan account holder from loaning money to the account. Likewise, the holder cannot guarantee borrowing by the account or cover its losses. Furthermore, annual contribution limits restrict new money that can be put into an account. Therefore, any option strategy that could result in losses that could not be covered with cash or by the sale of liquid securities held by the account or by amounts which can be contributed to it within permitted levels should be strictly avoided. Otherwise, it would not be possible to cover account losses without committing a prohibited transaction or over contributing to the account, both of which result in unfavorable tax consequences, including the potential of tax penalties.
In the event an IRA or Keogh Plan account holder pursued the strategy of writing calls on a cash-settled index option, such as writing a call based on the Dow Jones Industrial Averagesm (ticker symbol "DJX"), and was assigned, the Internal Revenue Code does not consider the settlement debit to the account to be a distribution or withdrawal. However, as noted above, the IRA or Keogh Plan should strictly avoid this strategy if the account does not have sufficient cash or liquid securities to cover any losses, or the beneficiary is prevented from contributing additional monies to the account due to annual contribution limits.
E. IRA or Keogh Plan Income Subject to Tax
IRAs and Keogh Plans are subject to income tax if they generate earnings that are considered to result from the conduct of a business or from leveraged investments such as rents from mortgaged real estate.31 The IRS has informally ruled that income from the purchase and sale of options is investment income that is not subject to these taxes.32 Likewise, although many types of option transactions require margin to protect the brokerage firm against losses, the IRS has ruled that the normal use of margin in connection with the trading of options does not give rise to taxable income for an IRA.33
Unlike margin purchases of stock, which involves borrowing the purchase price of the stock from the broker and depositing cash or liquid securities as collateral for that loan, a margin deposit made in connection with certain option transactions protects the broker against losses, but does not involve borrowing from the broker. As long as the purchase price for an option is paid in full by its settlement date and as long as any required margin deposits are made within the specified time period, there is no borrowing involved in the transaction and, therefore, no debt-financed income. If, however, a buyer of an option fails to pay for the option on settlement date or a seller of an option fails to make a required margin payment and the broker extends credit to make the settlement or margin payment, this would constitute debt financed income. Therefore, in the event an IRA or Keogh Plan does not have sufficient cash to pay for an option or margin payment, either the options themselves or other assets must be liquidated to avoid extension of credit.
The foregoing is provided only as general information and should not be relied on as definitive legal or accounting advice. An IRA or Keogh Plan contemplating the use of options as a part of an investment strategy should consult its own counsel and accountants before making a final decision with respect to such a program.
Endnotes
Return The term "Keogh Plan" applies to any qualified retirement plan that covers self-employed individuals. At one time, there were substantial differences between these plans and plans sponsored by corporate employers, but these distinctions are now largely gone. The term "Keogh" takes its name from the Congressman who sponsored legislation in 1962 to permit the self-employed to maintain qualified retirement plans.
Return Pensions & Investments (May 12, 1997), p. 27.
Return "Premium" is the price of an option contract, determined in the competitive marketplace, which the option buyer pays to the seller for the rights conveyed by the option contract.
Return See "The Protective Collar" section of this paper for a discussion of index options.
"Return Exercise" means to invoke the right under which the holder of an option may buy (in the case of a call) or sell (in the case of a put) the underlying security.
Return Each option contract represents 100 shares of stock, and the price per contract is 100 times the quoted price of the option.
Return A put option contract gives its holder the right, but not the obligation, to sell the underlying security at a specified price (the strike) for a certain, fixed period of time.
Return The expression "JAN 105" means that the strike price is 105 and the put expires in January.
Return Each option represents 100 shares of stock.
Return All CBOE options on individual stocks are "American-style." This means they may be exercised at any time between purchase and expiration. Most index options are "European-style." These options may only be exercised during a specified period of time just prior to their expiration. The last day to trade these options is, usually, the Thursday before the third Friday.
Return "LEAPS©" or "Long Term Equity AnticiPation Securities?" are long-term options. LEAPS can have terms as long as 39 months to expiration.
Return Call options do not pay dividends, nor do they grant voting rights.
Return See "Employer Stock May Be Risky For Nest Eggs," Wall Street Journal, Feb. 11, 1998, p. C1. This article states: "... Americans have as much as one-third of their 401(k) and other retirement-plan savings invested in shares of their employer's own stock, an investment choice that may not be particularly prudent."
Return The use of index options to hedge equity market risk involves tracking error. This is the risk that the index does not move in tandem with the investor's underlying exposure.
Return Investors selling index options in an IRA must be able to meet exercise obligations, as discussed in the "Tax Considerations" section of this paper.
Return If the DJX is above the call strike (88.00) at expiration, the call seller pays the cash difference between the DJX settlement value and the (88.00) strike. Also note that DJX options are "European-style." This means that the call seller does not risk exercise by a call holder before the exercise period (but may purchase the call in the open marketplace in order to close out the position).
Return If the DJX is below the put strike (80.00) at expiration, the put buyer receives the cash difference between the put strike (80.00) and the DJX settlement value. Also note that DJX options are "European-style." This means that the put buyer may not exercise before the exercise period (but can sell the put in the open marketplace in order to close out the position).
Return The contribution requirements and limits for IRAs have changed from time to time. See I.R.C. Sec. 219. In 1998, the limit is $2000 in any one year or 100% of compensation, if less. A taxpayer and spouse may contribute up to $4000 per year. Contributions are deductible in whole or part if the individual is not covered by a qualified retirement plan during the year or if compensation does not exceed certain permitted levels. In 1998, contributions are not deductible if the individual is covered by a qualified plan and income exceeds $60,000 for married taxpayers filing a joint return. If an individual is not covered by a plan, the individual may deduct up to $2,000 even if the spouse is covered by a plan as long as income does not exceed $150,000 for married taxpayers filing a joint return. Non-deductible contributions can be made up to the $2000 limit even if the deduction is limited or denied. A special type of plan, called a Simplified Employee Pension ("SEP"), permits annual IRA contributions by an employer of up to the lesser of 15% of compensation or $30,000. See I.R.C. õ 408(k).
Return Distributions from a qualified retirement plan can normally be transferred tax free into an IRA or another qualified employer-sponsored retirement plan. See I.R.C. ss 402.
Return It is beyond the scope of this paper to discuss fiduciary rules in detail. However, plans that are subject to ERISA (discussed later) are not subject to state laws regulating trust investments, since ERISA preempts state laws that would otherwise regulate the management of plans subject to ERISA. Trusteed Keogh plans that are not subject to ERISA and trusteed IRAs are subject to the trust laws of the state where the trust is located. Almost all states have adopted a rule that requires a trustee to invest trust funds as a prudent man would but the application of this rule varies widely from state to state. Further, the investment standard may normally be varied by the terms of the trust instrument. In all cases, trusteed IRAs and trusteed Keogh plans must be examined in light of local law and the trust instrument to determine the extent to which option strategies are permissible.
Return However, Registered Representatives and broker-dealers recommending the purchase or sale (writing) of options must nonetheless reasonably believe that the recommendation is appropriate in light of the customer's investment objectives, ability to withstand risks, and level of sophistication.
Return In 1998, Keogh Plan participants can have contributions as high as $30,000 or 25% of taxable earned income, if less.
Return 29 U.S.C.A. 1101 et. seq.
Return 29 U.S.C.A. 1104.
Return Letter from Olena Berg, Assistant Secretary, Pension and Welfare Benefits, Department of Labor, to Eugene Ludwig, Comptroller of the Currency, March 21, 1996.
Return 29 C.F.R. ss 2550.404c-1.
Return See 29 C.F.R. ss 251.3-3(b).
Return I.R.C. ss 4975.
Return The term "disqualified person" includes a fiduciary; anyone providing services to the plan or account; the employer; any union representing employees participating; a 50% or greater owner of the employer or union; a family member of any of the foregoing; businesses 50% or greater owned by the foregoing (except family members); and officers, directors, 10% shareholders and highly compensated employees of the employer, union, their owners or businesses they own. See I.R.C. õ 4975(e)(2).
Return Prohibited transactions include the sale, exchange or leasing of property; lending of money or other extension of credit; furnishing of goods, services or facilities; transfer to, or use of the assets or income of the plan or account; fiduciary self-dealing with plan assets and kickbacks from third parties dealing with the plan or account. See I.R.C. ss 4975(c)(1).
Return I.R.C. ss 511 through 514.
Return Private Letter Ruling 8832052.
Return Ibid. |
