Trading in short-term options has become a popular investment strategy for many investors using personal funds. However, a growing number of investors who have been dealing with a high short-term capital gains tax, have been looking for a more tax advantageous strategy. Enter the Self-Directed IRA. This article will explore how option trading works and explain how using a Self-Directed IRA can serve as a savvy tax advantage.
What is Option Trading?
Options trading gives one the right or obligation to buy or sell a specific security on a specific date at a specific price. An option is a contract that’s linked to an underlying asset, e.g., a stock or another security. Options contracts are generally good for a set period, which could be as short as a day or as long as a couple of years.
When one buys an option, you have the right to trade the underlying asset, but you’re not obligated to. If you decide to do so, that’s called “exercising the option.” When you sell an option, you must fulfill the contract. Selling options is where things get more complicated, and you could be at risk of losing an unlimited amount.
What is buying a call?
A call option gives one the right to buy an underlying security at a designated price within a specific period. The price one pays for the option is called the strike price. The end date for exercising a call option is known as the expiration date.
What is buying a put?
A put option is basically the opposite of a call option. Instead of having the right to buy an underlying security, a put option gives one the right to sell it at a fixed strike price. Put options also have expiration dates.
What is Short-Term Option Trading?
Options enable traders to leverage their bets on individual stocks. With an option, one gets the right, though not the obligation, to buy or sell shares at a set price by a stated date. In the past, options trading was seen as best left to professional firms with access to advanced trading tools and data. However, in the past several years, a new era of individual option traders has emerged focusing on short-term options.
According to a Wall Street Journal Article, shorter-dated options, expiring in five or fewer days, accounted for about half of all options-market activity as of August according data provider SpotGamma, up from around one-third three years ago. Individual investors made up 27% of all activity in options as of June, up from 23% at the start of 2020, according to Bloomberg Intelligence. For popular one-day options tied to the broad S&P 500 index, individual investors made up around one-third of all trades, according to exchange-operator Choe Global Markets. Shorter-dated options bets have become so popular they have their own nickname, 0DTE, shorthand for zero days to expiration.
Taxation of Options
In general, if you are investing in puts or calls, the gains or loss from an option transaction is subject to the capital gains tax regime.
For long call options, if you close the position before exercising, the holding period of the option determines if it’s taxed at short- or long-term capital tax rates. Whereas if you exercise the option, the cost basis of the stock that is purchased is increased. There is no taxable event until the stock is finally sold. However, once the stock is sold, the holding period of the stock determines if the capital gain or loss is short- or long-term. For long put options, all the same rules apply as long call options, except that exercising a put option reduces the amount realized from the sale of the underlying stock by the cost of the put.
In the case of a short call option, if the option position is closed before the expiration period, regardless of holding period, the capital gain or loss is always considered short-term. Whereas if you exercise the option, the capital gain or loss is treated as short- or long-term depending on your holding period for the stock.
In addition, the amount you received for writing the option is added to the amount received from the sale of the stock. However, for a short put, the holding period for the stock begins on the date you buy it. If the put option is exercised and you buy the underlying stock, decrease the stock’s cost basis by the amount received for writing the option.
Taxation of a Self-Directed IRA & Roth IRA
The advantage of using a Self-Directed IRA to make option investments is that all gains are either tax-deferred or tax-free in the case of a Roth IRA.
The concept of tax deferral is prefaced on the notion that all income and gains generated by the pretax retirement account investment would generally flow back into the retirement account without tax. Instead of paying tax on the returns of an IRA investment, tax is paid only later, leaving the investment to grow unhindered.
Alternatively, when using a Roth, since contributions are made with after-tax money, all qualified distributions are tax-free. To be qualified, the Roth must have been opened for at least five years, and you must be at least age 59 ½.
Capital Gains & The Self-Directed IRA
As discussed earlier, gains from an option call or put would generally be subject to capital gains tax. The beauty of using a Self-Directed IRA to invest in short options, is all gains are not subject to tax. There is no need to worry about basis or holding period since all gains are exempt from all tax, including capital gains tax.
Are Options Subject to the UBTI Tax?
In general, almost all Self-Directed IRA investments that generate passive categories of income will not be subject to Unrelated Business Taxable Income (UBTI), such as capital gains, interest, dividends, royalties, and rental income. In 2023, the maximum UBTI tax rate is 37%. The good news is that option trading has been determined by the IRS not to be subject to the UBIT tax regime.
The IRS held that income or gains connected with short sales does not become subject to tax by the “acquisition indebtedness” rules contained in Section 514. They ruled that the borrowing of securities by the short seller does not create an indebtedness for federal income tax purposes. Similarly, the cash sale proceeds arising from the short sale are treated as sales proceeds and do not arise from an indebtedness.
Investing in options, especially short-terms options, is risky and can produce quick losses. However, there is also the opportunity to generate significant gains. The major tax advantage of using a Self-Directed IRA or Roth IRA to invest in short-terms options is that the gains are tax free. There is no need to worry about one’s basis in the option or the holding period since all gains would not be subject to any ordinary income or capital gains tax. It is for this reason that many savvy option investors are self-directing their retirement instead of using personal or non-retirement funds.