The COVID-19 pandemic introduced millions of investors to the idea of margin trading. Buying stocks on margin can appear like a can’t miss way to make money. If you have a couple thousand dollars in your brokerage account, you could qualify to borrow money against your existing stocks or cash at a low interest rate. You would then be able use that borrowed cash to buy even more stock. In theory, this could allow you to supercharge your returns. Stock speculation may be a dangerous game for some.

That being said, margin trading is a fundamentally risky strategy that can turn a relatively safe stock investment into a high stakes bet. It allows assertive investors to buy more shares than they could otherwise afford. When things go well, these investors make a lot of money. When things go bad, it can get really nasty, really quickly.

What is Margin?

In general, margin stock investing occurs when an investor borrows money to pay for stocks. Typically, the way it works is your brokerage institution lends money to you or your retirement account at relatively low rates. In effect, this gives you more money to buy stocks—or other eligible securities—than your cash alone would provide

Your account, including any assets held within it, then serves as collateral for that loan.  However, in some cases, a personal guarantee may also be required to secure the margin loan.  Also, the brokerage firm can legally change key terms at any time, such as how much equity you need to maintain In other words, the brokerage firm is just lending you money. Regardless of how the stock performs, you will be on the hook for repaying the loan.

What is a Margin Call?

A margin call occurs when you’re required to add cash or securities to your account.  This occurs when the value of the assets in your account dip below a certain value needed to secure the margin loan. If you can’t swiftly deposit the cash or stocks to cover the margin call, the brokerage firm can sell securities within your account at its discretion.  In such cases, the brokerage firm is typically selling stocks that have dropped in value, further deepening the individual investor’s losses.

The Pandemic Effect

Due to the COVID-19 lock-down, most Americans were stuck at home, many with $1,200 stimulus checks or rent/loan moratorium, no vacation spending, and no sports to watch or bet on.  So what did many do?  They went to the stock market, then realized that options have similar payoff structures to sports bets.

Online no-commission trading platforms have seen a surge in popularity sine the start of the pandemic.  Robinhood promotes its margin option for investors.  A recent report by JPM estimated the brokerage industry added more than 10 million new accounts in 2020, with Robinhood alone likely representing about 6 million. At the same time, investors have also levered their holdings and margin debt is at an all-time high.

Margin & Self-Directed IRA

In general, Internal Revenue Code Section (“IRC”) 4975 prohibits an IRA holder from engaging in any transaction that involves:

(A) sale or exchange, or leasing, of any property between a plan and a disqualified person;

(B) lending of money or other extension of credit between a plan and a disqualified person;

(C) furnishing of goods, services, or facilities between a plan and a disqualified person;

(D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;

(E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or

(F)  receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

A “disqualified person” is essentially defined as the Self-Directed IRA holder and any of his or her lineal descendants as well as any entity controlled by such persons. 

So long as one is not required to personally guarantee the margin used in the investment and the only collateral being used is the underlying securities or cash, then the use of margin in an IRA would not trigger the IRS prohibited transaction rules.  However, if one is required to personally guarantee the IRA margin obligation, then that activity would seemingly violate the IRS prohibited transaction rules under IRC Section 4975(c)(1)(B).

Margin & UBTI Tax

Almost all retirement account investments generating passive income will not be subject to Unrelated Business Taxable Income (UBTI or UBIT) or Unrelated Debt Finance Income (UDFI) Tax.  However, the UBTI tax is triggered in three circumstances:

Hence, if a Self-Directed IRA uses margin to buy stock or securities and the IRA holder is not required to personally guarantee the margin loan, the UBTI tax would apply to the gains attributable to the margin percentage.  For example, by way of a simple example, if one had $100 in their IRA and borrowed an extra $100 to buy AMC stock, 50% of the gains would be subject to the UBTI tax, which has a maximum tax rate of 37% over income above $13,000 or so of income.

Conclusion

If you are considering using margin to buy stocks beware of the risks.  In addition, if you will be using retirement funds, be mindful of the IRS prohibited transaction and UBTI rules. Stock speculation is not for the faint of heart. Never “gamble” more than you can afford to lose. There’s never a sure thing in the stock market. If it’s too good to be true, it probably isn’t!