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TRADERS
SERVICES: RETIREMENT
PLAN STRATEGIES FOR TRADERS
2009 year-end tax planning with Roth IRA conversions. Click
here for Robert A. Green, CPA's blog article. We also discussed Roth
IRA conversions on our podcast dated Sept. 24, 2009. Click
here for our podcast archives.
Important Update on July 15, 2009. Click
here for Robert A. Green, CPA's 10-page blog article (in pdf format)
on retirement-plan strategies for traders. This same article is being
edited into a shorter version for Green's Business of Trading column in
Active Trader magazine (October 2009 issue). This article covers self-directed
and administered Mini 401k plans (tradtional and Roth) and IRAs, where
you can achieve far greater flexibility in making alternative investments,
plan loans (qualified plans only) and payment of trading expenses (a good
feature when you don't have trader tax status).
Traders
Have Retirement Choices - Short video produced by MoneyShow.com
featuring Robert A. Green, CPA. "Author and trader tax expert Robert
Green reviews some of the retirement account options available to today's
traders and how some may allow traders to write off expenses and trading
costs." Released: 7/16/2009.
Click here for updates to a
previous blog (May 29, 2009) and our significant earlier content on retirement
plans over the past decade.
GreenTrader Retirement-Plan Services:
It's best to start with a retirement-plan consultation.
GreenTraderTax offers numerous educational resources and consulting services to traders on setting up and utilizing existing retirement plans in a tax-advantaged manner. Whether you want to:
* actively trade (securities, futures, or forex) and/or make alternative
investments directly within your retirement plans;
* build up your retirement funds with high annual tax-deductible contributions;
* borrow up to $50,000 from a qualified plan (note: IRAs do not qualify)
to help start a trading business entity with trader tax status (or for
any other reason);
* convert your traditional IRA or qualified plan to a Roth IRA for permanent
tax-free build-up (with a special one-time opportunity in 2010 that removes
income thresholds);
* or take early withdrawals with fewer tax pitfalls (no 10-percent excise
tax on substantially equal periodic payments);
we can help you accomplish your goals.
There are many nuances, complexities and tax pitfalls (excise taxes on prohibited transactions and more) with retirement plans, and it’s even more nuanced when you factor in special tax matters (such as trader tax status) for business traders versus investors. As a leading CPA firm for traders, we provide many different strategies for using retirement-plan assets in the most tax-efficient manner, and you will be pleased!
We work closely with several different retirement-plan vendors (brokerage firms and intermediary trust companies) and our retirement-plan consultants will help you choose the best options for your needs, incorporating our best retirement-plan ideas, trader tax status, and entity-formation strategies. You pay these other providers directly; there’s no mark-up from our firm. We help you in a variety of ways with the retirement-plan options, features (such as loan provisions), IRS and other DOL & ERISA rules and compliance, trader tax status, entities, tax-deductible retirement-plan contribution options, Roth conversions and much more. Consult with us to determine your individual retirement-plan options and on plan set up as well. We also prepare annual tax Form 5500s when needed, and form your entities and prepare your annual income tax returns as you like.
After
your initial consultation, you can either continue with 30-minute consultations
as you need them or upgrade to a retainer plan below.
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Prior Main Content in this Retirement-Plan Section:
May 29th blog article re-edited after the important updated July 15th blog article above:
You only need trader tax status if you want to make annual tax-deductible contributions to a retirement plan (or tax-free contributions to a Roth IRA). An entity with trader tax status can efficiently pay a tax-deductible (from gross income) administration fee, which creates the earned income needed for a retirement-plan contribution. Without trader tax status, that administration fee is only deductible as a miscellaneous itemized deduction, which is significantly limited with the 2-percent AGI limitation and add-back for AMT purposes (the nasty second-tax regime). That makes it less tax-efficient.
It’s wise to get a handle on your retirement-plan strategies in 2009, as a one-time only window of opportunity opens in 2010 with the last of the Bush tax cut breaks. All taxpayers can convert a traditional IRA (temporarily tax-free) to a Roth IRA (permanently tax-free) in 2010, as the annual income threshold of $100,000 of modified adjusted gross income (MAGI) is waived in 2010 only. Normally, in all other years, only taxpayers with MAGI of $100,000 or less can convert a Roth IRA. Business traders with large Section 475 MTM ordinary losses and even NOLs (net operating losses caused by MTM losses) can choose to absorb those losses with a Roth IRA conversion (a great strategy for 2009 too). You can also take advantage of lower tax rates in years with less income with a conversion. You can pay the conversion taxes in 2010 over two years too. We will have more content on this Roth IRA conversion strategy — check back soon.
It’s important to note that GreenTraderTax and the government — the Department of Labor under the Employee Retirement Income Security Act (ERISA) — also advocate long-term safety for retirement funds. Caution should be used to avoid “self dealing” and “prohibitive transactions” which are subject to onerous IRS tax penalties (details below). We offer great ideas and ways to tap your retirement funds for active trading, but we also want you to be cautious and consider the down side. We don’t want to enable individuals to lose their retirement funds in active trading and alternative investment activities.
We suggest starting with a half-hour consultation with our GreenTrader retirement-plan experts (Robert A. Green, CPA or Mark Durham, MBA). If we both agree that a GreenTrader self-directed retirement plan is a wise strategy for you and your family, we would be happy to consult with you further or you can upgrade to our retirement-plan services retainer (click here to learn more).
We provide consultation, design, execution-assistance (formation) and annual compliance and support services. We ask you to pay for third-party providers (if required) directly to avoid price mark-ups and to ensure that you will receive these third parties’ direct care and support. In some cases, we will negotiate special lower pricing and/or value-added services from our affiliates; it pays to work through us. We make sure to use these providers in every way possible, so you don’t pay us to do what’s included in their fixed prices. If you don’t need the added features of an intermediary trust retirement plan, we suggest a “cookie-cutter” self-directed retirement plan offered by leading brokers (which often costs much less).
As with our popular entity formation service, we don’t just form a retirement-plan strategy and walk away. Our clients count on us to provide ongoing support and annual service to ensure the plan works as designed, reaping all possible benefits in a compliant manner. Just as with our entity-formation and tax-preparation services, the final tax saving comes at tax time (year-end planning and preparation), when we crunch the numbers to see the various savings from different strategies.
We also prepare your annual tax Form 5500 Annual Return/Report of Employee Benefit Plan (if required) and handle annual maintenance and upgrades for your plan. Congress and the IRS often update employee benefit laws, and it’s vital to keep your plans compliant with all changes in the law. Our third-party providers make sure the plan paperwork reflects any changes.
Our retirement team consists of a leading retirement plan-professional (Mark Durham, MBA joined us after a 22-year career with Fidelity Investments), a retirement-plan/employee-benefits attorney (Louis Barr, JD) , a tax attorney (Mark Feldman, JD), a CPA from our trader tax practice area (Jaren Durham, CPA) who also is an expert in preparing 5500s, all our CPAs, and Robert A. Green, CPA/CEO.
Our retirement-plan content (including many magazine articles) below has grown over the years. It’s now better than ever with the 2009 roll out of our new GreenTrader self-directed retirement-plan services and related strategies (see below).
Here is the evolution of our retirement plan services and content for traders.
In 2000, we pointed out the great tax pitfall of traders taking “early withdrawals” from their retirement plans to fund their trading accounts. Many of these traders got caught in a double-tax whammy when the tech bubble burst. They were forced to pay very high income taxes on their early withdrawals from retirement plans (at higher ordinary income tax rates), plus they had to pay the onerous 10-percent excise tax penalty (reported on IRS Form 5329). The painful lesson back then was that too many business traders neglected to also elect Section 475 MTM (to protect themselves with ordinary loss treatment), so they were stuck with restricted capital loss treatment and had to carry over large trading losses to subsequent tax years (and many never used them in later years). The sad result was that they paid taxes on essentially breaking even. Many of these traders wound up owing the IRS and their states more than they could pay. With Section 475, they could have offset their retirement-plan early withdrawal ordinary income with Section 475 MTM ordinary trading losses, thereby not owing any tax except the 10-percent excise tax. The remedy at that time was to trade within your retirement plans and if you took early withdrawals, to make sure you elected Section 475 MTM. This same problem happened again in 2008 for many traders caught in the meltdown.
Now we are pleased to offer broader and better remedies to traders facing this conundrum and who need to access funds in their retirement plans for trading and other personal and business uses.
What’s changed? More brokers offer direct-access trading in cookie-cutter (free) IRAs in securities, futures and even forex. Good intermediary trust companies and even one broker (TD Ameritrade) offer qualified plan loans of up to $50,000, which traders can tap into to finance a trader tax status business entity. These trust companies provide qualified plan trading at most leading brokers, including many of the ones that don’t have their own qualified plan products (the preferred plan of choice for business traders is still the Mini 401(k) plan)
In the 2009 jobs recession and credit crisis, many people, including traders, are facing cash-flow shortages and the withdrawal of credit lines (on home equity loans) from their banks and credit card providers. Many traders are unable to finance their working trading capital and other living needs, especially after incurring large trading losses in 2008 and 2009 year-to-date. Finding a legal and tax-efficient way to tap into retirement funds to finance a trading business and/or living expenses can be a wise move (of last or first resort). Again, be cautious and think twice about using this type of financing to fund a losing business.
The key is using your retirement funds in a tax-efficient manner and not falling into a pitfall leading to ordinary income taxes, 10-percent excise taxes and onerous prohibited transaction penalties and consequences.
Even non-business-traders (active investors) with other business activities (such as me —an accountant) are interested in these retirement-plan strategies. As an example, if you are a conservative investor and have your retirement plan assets invested mostly in cash equivalents earning very low interest rates, consider borrowing from your retirement plans to pay down your mortgage and/or credit card debt, which probably has much higher interest rates (interest rates are sky rocketing on credit cards and remain high on jumbo mortgages too). Saving several basis points on interest rates is wise, even after forgoing some mortgage interest expense tax deductions. Personal-use credit card interest is not deductible, so focus on that first. As explained above, IRAs are unable to disperse a plan loan. You need a qualified plan, such as a business Mini 401(k) plan or a SEP IRA (self-employed business IRA).
We recommend the following strategy for established business traders. Borrow some retirement-plan funds to sufficiently replenish your trading business accounts in order to maintain your trader tax status and Section 475 MTM treatment. Some traders have fallen below “pattern day trader” amounts of $25,000 for securities and their broker then restricts day trading, only allowing 2/1 margin (rather than 4/1 margin for pattern day traders). A retirement-plan loan can be the answer. But don’t borrow all the money you can from the plan (up to 50 percent) — borrow only enough to replenish what you need.
The maximum term for a participant loan generally is limited to five years (unless financing the purchase of a residence). Participant loans are required to be amortized substantially evenly over the loan term, with at least quarterly payments of both principal and interest.
The loan must bear a reasonable rate of interest. The interest is treated as investment return and not a contribution. Accordingly, there will not be a basis adjustment and it will generate ordinary income upon distribution.
Even if otherwise deductible, the interest expense would not be deductible if the loan is a loan to a key employee or secured by amounts attributable to elective deferrals to a 401(k) plan.
Unfortunately, the interest part of this strategy is not very tax efficient, as the interest expenses (paid by the taxable account to the retirement plan) is not tax deductible. On the flip side, the interest income is ultimately taxed as part of later-year retirement-plan distributions. There is a benefit in that the interest income is not part of the annual retirement plan contribution limits — so you wind up with a higher payment into the retirement plan, which generates more tax-free build-up.
Why borrow the maximum amount allowed and then have to pay it back to the retirement plan over five years, after you pay annual taxes on the trading gains related to that plan loan funding? It may be wiser for you to leave as much of those retirement-plan assets as possible in the retirement plan itself and trade the plan as you like (securities, futures and forex in a self-administered plan trust account). That way, you build up the retirement assets without having to pay annual income taxes on the gains. If you have large losses with Section 475 in a taxable account (with full retirement-plan loan funding), you will enjoy NOL immediate tax-refund treatment. However, the IRS is beefing up attacks on trader tax status and if yours is weak, it may be more prudent to trade in the retirement account instead. Growth from tax-free compounding is far better than paying taxes every year in a taxable account.
We suggest a consultation with Robert Green and/or our retirement-plan expert Mark Durham, MBA to determine the best strategy for your needs.
Green will consult with you on qualification for trader tax status and if you can benefit from an entity and a retirement-plan contribution. He and/or Durham can advise you on using a retirement-plan strategy along with trader tax status and your entity, or using a self-administered retirement-plan strategy as a regular investor (to have plan loans and rights to trade securities, futures and forex).
We can fine tune the best overall retirement-plan strategy for you and work together with you and our affiliates to find the best cost versus benefits plan.
It’s important to note that trading securities on margin in your retirement plan (through an underlying hedge-fund investment) leads to Unrelated Business Taxable Income (UBTI) and Unrelated Business Income Tax (UBIT). Current tax law dictates that margin interest paid on trading also means the trading gains and income generated from that leverage (part only) is subject to annual income taxes — and is otherwise not protected by the tax-free status of the retirement plan.
Pension funds and college endowments invest in offshore hedge funds to avoid UBIT caused by using leverage in a domestic fund. Offshore hedge funds are known as “UBIT-blockers.” As part of Congress and the Obama administration’s agenda to reduce offshore tax breaks, Congress has proposed tax-law changes to encourage pensions and other tax-free institutional funds to invest in domestic funds rather than offshore funds. Congress proposes to eliminate the UBIT blocker tax loophole, not by causing offshore funds to generate UBIT on par with domestic funds, but rather in a more positive manner — by simply removing UBIT entirely in domestic funds.
These potential changes to UBIT rules could help traders using their own retirement plans too. Perhaps UBIT won’t apply in this instance either. It’s also important to note that trading futures and forex in a retirement plan does not generate UBTI as that type of leverage does not generate margin-interest expense.
Notes from our attorney on UBIT issues:
• Qualified plans are subject to the unrelated business income tax (UBIT) on its unrelated business taxable income (UBTI). While interest income and securities gains are generally considered exempt from UBIT, if an investment is "debt financed," it is subject to tax in proportion to the financed amount. Accordingly, margin investments within a plan may be taxable. Also, revenue received from unexercised stock options (puts and calls) regularly issued on stocks held in the trust's portfolio may constitute UBTI and not "passive" investment income.
• Points for possible additional review:
A. Since there is no tracking of loan proceeds, there should be no prohibited transaction issue (not a plan investment); however, in the event that the business adopting the plan is premised on the use of a plan loan, query as to whether the validity of the business will be questioned.
B. Even though non-financed investment activities generally do not generate UBTI, will active trading ever rise to the level of an "unrelated business" if trust funds are utilized as a "trader" activity?
Comment from Green. We don’t want a taxable trading business (or hedge fund) to be solely funded from a retirement plan account. Rather, we prefer it to be less than 50 percent funded so the IRS can not take the position that the retirement plan is running a business.
Borrow what you need and leave as much of those assets as possible within your retirement plan, and trade them in the retirement plan as you like (securities, futures and forex). The funds traded within the retirement plan build up tax free until retirement (and they are permanently tax free in a Roth IRA). Trading losses incurred within the retirement plan reduce your tax basis, which reduces taxes to be paid on later year distributions from the plan. If you need to cover more living expenses later on, perhaps because you have trading losses in your taxable accounts, you can always borrow more retirement assets as you need them over time. We recommend this strategy rather than taking a larger loan to start.
Many traders have been asking us for these value-added retirement-plan features. They want the ability to borrow money from their own retirement plans to finance their trading business, especially during this recession. Their brokers have said no. Their only alternative has been taking an ill-advised early withdrawal from their retirement plans, subject to ordinary income taxes plus a nasty 10 percent excise tax penalty.
We can set up a GreenTrader self-administered retirement plan to meet your specific needs. Self-administered means you (and not our firm) are responsible for your investment decisions. (We don’t offer investment advice because GreenTrader is not an investment adviser.)
We provide support for compliance and administration, including 5500 tax filings, loan agreement setup and maintenance.
Many of our plans are fairly simple to set up and reasonably priced. The added-value features and tax benefits far exceed the set up and annual maintenance costs.
If you are interested in a GreenTrader self-directed retirement plan, please email us at retirementplans@greencompany.com and tell us the features you are most interested in.
Our retirement-plan professional Mark Durham, MBA, recently joined us after a long and successful career at Fidelity. Mr. Durham is working on these plans along with Robert Green, CPA, and our outside employee-benefits attorney, Louis Barr, JD, and tax attorney, Mark Feldman, JD. We are using the leading non-prototype plan engines with opinion letters, too.
Prior content:
Every consistently profitable trader should have a retirement plan. Many
plans provide for a tax deduction on annual contributions, and this generates
immediate tax savings – sort of like an immediate high rate of return
on your investment. Plus, you benefit from tax-free compounded returns,
which can far exceed taxable returns.
See the incredible savings with a small Mini 401K plan contribution
- click here.
Article: Traders, go long your retirement funds. Trading
retirement funds can save loads in taxes. This article is the second of
two pieces explaining how traders should plan for retirement. See the
September 2004 issue of SFO magazine. Click
here to learn more.
Article: Do you sincerely want to retire one day? Market forces
may force you into “early retirement.” Traders face special
rules in retirement planning and you should start (or update) your retirement
planning now. Learn how to get significant income savings from tax-deductible
retirement-plan contributions while limiting your self-employment taxes.
Most likely, you will need an entity to create “earned income,”
so learn which type of entity is best suited for your needs. Robert Green's
article submitted to SFO Magazine for their August 2004 issue.
Article: Enhance your retirement (accounts) by making prudent investments with asset diversification and liquidity. If you want to use your retirement plan accounts as part of your day or swing trading business, watch out – you could be in for some nasty surprises from the IRS and ERISA! We can explain the rules and some limited ways to navigate around the rules. Robert Green's article for Active Trader magazine in their February 2004 issue.
We help choose the right plan for your needs and customize a trading-business
entity or investment company to execute the retirement plan strategy (and
other strategies).
IRS Form 5500 ERISA Annual Report: ERISA (retirement)
plans must file an annual report to the U.S. Department of Labor (DOL)
each year on Form 5500 or Form 5500-EZ. These forms are due by Aug. 1
of the following year (2004 Form 5500 is due Aug. 1, 2005). An extension
is allowed on Form 5558; file the extension by Aug. 1 to extend your 5500
or 5500-EZ until Oct. 15th. Mini 401(k) plans are ERISA plans so they
must file these forms. IRAs are not ERISA plans so they don't file Form
5500. Click here to learn more.
Hire our firm to plan and establish your Mini 401(k) retirement plan before
year-end. You can fund it after year-end, but it must be "papered"
before year-end. Note: Traders without any other source of earned income
need a trading entity to pay themselves earned income as a basis for a
retirement-plan contribution. Click
here to learn more about entities for traders. We can help you figure
out the maximum tax savings possible versus SE taxes to be paid and how
much you can afford to contribute to a retirement plan.
Your cost of forming the entity (needed for a trader-retirement plan),
including GTT's fees and state-filing fees, is around $850. In future
years, you don't have this one-time cost. Click
here to learn about our GTT Entity Formation Services.
If you have a very successful year and can afford to contribute more to
your retirement plan, we recommend you contribute the maximum allowed
– $42,000 for 2005 and $44,000 for 2006 (to a Mini 401(k) plan or
other type of defined contribution plan). In that case, you can expect
even greater net savings, and you'll be able to grow more money in a tax-deferred
account. You can save even more with a Mini 401(k) defined benefit plan,
which is available from a few brokers now (try Pioneer, Schwab and Fidelity;
see some links below).
The major tax reason why the Mini 401(k) is the most attractive retirement
plan for traders is that you can contribute the maximum $42,000 on a lower
fee income (of approximately $148,000). With other profit-sharing retirement
plans, you must use the maximum fee compensation allowed of $210,000 to
get the $42,000 contribution limit (or just less than $42,000, after deducting
half the SE tax). With the Mini 401(k) plan, you save SE taxes (the 2.9%
Medicare portion) on the difference in the fee amount, which translates
to a savings of around $1,800.
More on the
law. Because current tax law treats administration fees as self-employment
income, these earnings can be used for making deductible contributions
to a Keogh plan. A Keogh plan is a retirement plan—either a traditional
defined benefit pension plan or a defined contribution plan, such as a
money purchase pension plan or a profit-sharing plan for self- employed
individuals. There are some special rules that apply to Keogh plans, but
essentially deductible contributions of up to 20% of this income—up
to a maximum of $42,000 (for 2005)—may be made to either type of
defined contribution Keogh plan. Keogh pension plans are funded in much
the same manner as employee pension plans. The amount of income that can
be set aside under these plans is substantially the same as under regular
employee pension and profit-sharing plans.
If a profit-sharing plan is selected, an additional benefit can be provided through the use of a “solo” or “mini” 401(k) plan. These are one-participant plans that, for 2005, allow for the contribution of up to $14,000 in regular 401(k) contributions, plus an additional $4,000 in catch-up contributions. “Solo” 401(k) plan contributions are subject to the same $42,000 limit on deductible annual contributions as the profit-sharing plan contributions. In effect, the “solo” 401(k) plan contributions would help to fill a portion of the $42,000 deductible contribution limit not used by the profit-sharing plan contributions.
If you are
interested in this type of trader-retirement savings plan, contact info@greencompany.com
or call us.
We recommend
a consultation
with Robert A. Green, CPA & CEO. He will review your tax and retirement
situation and consult you on the best retirement plan for your needs.
IRS
Publication 3998: Choosing a retirement solution for your small business.
IRS
Publication 560: Retirement Plans for Small Business.
If you have any questions on retirement plans for
traders, send us a confidential e-mail at info@greencompany.com
or call us.
Ready for Help? Click
here.
Trading for
your RETIREMENT:
An article by Robert A. Green, CPA, appeared in the February 2004 issue
of Active
Trader magazine: Trading for your retirement. Many traders want
to actively trade their retirement plans. For some it's a bad idea; for
others it's a nice way to benefit from tax-deferred cumulative returns.
However, there are limitations to what you can do with a retirement account,
so take some time to learn the rules before actively trading your retirement
plan.
Important update on March 12, 2004: We point out in our
below article that there are several limitations in trading your retirement
accounts, such as a business-activity (hyperactively). Since writing this
article, one more significant limitation has arisen as a result of a recent
NASD crackdown on credit abuses in "cash accounts." Click
here to learn more.
Here is the original article submitted, before editing by the magazine.
Enhance your retirement (accounts) by making prudent investments with
asset diversification and liquidity. If you want to use your retirement
plan accounts as part of your day or swing trading business, watch out
– you could be in for some nasty surprises from the IRS and ERISA!
Learn the rules and some limited ways to navigate around the rules.
By Robert A. Green, CPA
The bear market clawed away at most traders’ working capital. Traders seek new sources of capital to ride the bull (markets) again.
Some traders are interested in joining proprietary trading to gain access to a firm’s trading capital, with a sub-trading account using leverage up to 10 to 1. Proprietary trading firms require a brokerage license and minimum capital of $25,000 or more.
Other traders are interested in forming their own hedge fund to raise capital from investors (friends, family and others) and to make money off “other peoples’ money.” This is a good opportunity for successful traders, but losing traders may have trouble executing this business plan.
A last resort for many traders is closer to home – their own retirement-plan assets. But before you start day trading your retirement assets, you should learn about many restrictions that apply.
Various government agencies regulate retirement-account investments. For the benefit of tax-free deferral or permanent savings, the government insists on investment protection, prudence, diversification, liquidity and no self-dealing.
There are limited ways to navigate around these rules to actively trade your retirement accounts. In all cases, try to follow the spirit of the law; prudence is a virtue and you want to retire one day on these assets. Throwing caution to the wind and losing all your retirement assets in risky day trading is not a wise undertaking anyway.
It’s not a perfect world!
In a perfect world, a business trader has sufficient capital to fund their trading business.
If a reasonable to aggressive return on trading capital is 25 to 50 percent, a trader needs capital of at least $200,000 to generate income of $100,000 – what many traders need to cover their living and business expenses. Certainly, the past few years have not been a perfect world for traders and many have suffered losses to their trading capital. Can you make a good living on trading capital of $25,000 or less?
For many traders their last resort for trading capital is their retirement-plan assets.
Take a cookie from the jar and you will get slapped (with penalties)
It’s not easy finding ways to take money out of your retirement plans to put in your trading accounts.
If you take money out of your retirement plan before retirement age, it's an “early withdrawal” subject to regular income tax (at ordinary tax rates up to 35 percent), plus a nasty excise-tax penalty of 10 percent. Many traders tap into their retirement plans figuring they have no income or losses and can take the distribution into income. They are later surprised and upset about the 10-percent excise-tax penalty (there are some exceptions which you can find at www.irs.gov or http://www.irs.gov/faqs/faq5-3.html).
Most qualified retirement plans allow for loans and you can use the loan proceeds to fund your taxable trading accounts. IRAs are not qualified plans and they do not allow loans.
Leave the money in your plan and benefit from tax-deferred trading
You don’t have to pay taxes and excise-tax penalties on early withdrawals to have access to trading your retirement-plan assets.
There are limited ways to leave the money in your retirement plans and trade it there for continued tax-deferral on the existing money and all the trading gains you generate. Short-term trading on securities is taxed at ordinary tax rates anyway, so when you retire and take distributions, you will have those same ordinary tax rates (tax laws can change the rates when you retire).
Find a financial calculator on the Internet and see the power of tax-free compounded returns. You will be impressed.
If it sounds too good to be true, well, it is. There are many pitfalls, restrictions and possible violations, so read on.
Brokers take a pound of flesh
Barron’s reviews and rates online and direct-access brokerage firms each year and they provide charts showing who has the lowest commissions. They are all low these days, a huge benefit for traders.
The problem is that when it comes to retirement-plan accounts, brokerage firms cover the gamut in terms of commissions (most are very high), number of allowed trades, and other terms and conditions. Some of their terms are based on ERISA and IRS rules and others are simply their own policies. We are doing our own survey now on retirement-plan brokerage accounts and will report on this soon in this column.
I have advocated Mini 401(k) plans (also known as solo or individual 401(k) plans) as a retirement plan of choice for traders, but most brokers still do not offer this product. Mutual fund companies offer Mini 401(k) plans, but most traders prefer a retirement plan they can trade (with efficiency and at low cost).
ERISA – what’s that and why should I care?
ERISA stands for the “Employee Retirement Income Security Act of 1974,” administered by the U.S. Department of Labor. To learn more about ERISA go to http://www.dol.gov/dol/topic/retirement/index.htm.
ERISA was passed to better protect employees’ retirement-plan assets. Far too many companies were abusing their company retirement plans for the benefit of management and shareholders, and not employees.
Before ERISA, companies could purchase only their stock in their retirement plans. Bankrupt companies took jobs and retirement-plan assets, and this could not continue.
ERISA saved the day for employees but makes life difficult for traders
A Department of Labor (DOL) ruling for ERISA on “plan
diversification” prevents a company from investing all retirement-plan
assets into its own stock, or any one stock. Certainly, this saves the
day for employees.
Company administrators are charged with a “fiduciary duty” to diversify investments and manage the risk of losses. Traders are very familiar with this type of risk management.
This rule presents a problem for many traders. Is active trading in an ERISA covered retirement plan a violation of the plan diversification rules?
There is no clear DOL or ERISA guidance or case law indicating how to apply the 25-percent plan-diversification rule to active trading. Each case should be evaluated on an individual facts and circumstances basis in consultation with a CPA or tax attorney specialized in ERISA and tax regulations.
Don’t panic, if you have an IRA or individual-level plan, you are exempt from ERISA rules
Before you start worrying about ERISA rules, find out if your retirement plans are even subject to ERISA regulations.
Some retirement-plan types are subject to ERISA rules, and others are not.
Individual retirement accounts, including traditional IRAs, Roth IRAs, Rollover IRAs and education IRAs, are not ERISA covered plans; therefore, IRAs are not subject to this 25-percent plan-diversification rule.
Even though you are not subject to ERISA rules, other IRS rules may serve to restrict your IRA investment activities. See below.
Mini 401(k) plans are ERISA plans. See Form 5500 rules below.
ERISA plans include all company-level plans including but not limited to 401(k) plans, traditional retirement plans and other qualified retirement plans.
This makes sense. Retirement plans that include third-party employees
are covered by ERISA, for the protection of those employees. But plans
for individuals without employees have significantly less government oversight
and protection. That’s the American way!
Individual-level plans are the plan of choice anyway
I usually advocate individual-level plans for traders; with a Mini 401(k) as the first choice and SEP IRAs as a second choice (if you miss the year-end establishment date on a Mini 401(k) plan).
To have the opportunity to fund a tax-deductible retirement plan, a trader needs to form a simple legal entity. This is done to create earned income, since trading gains are not earned income.
The entity pays the individual trader a fee (which is the earned income) and the trader establishes a retirement plan on the individual level, not the entity level.
All IRA retirement plans effectively navigate a trader around many ERISA rules, including the 25-percent rule for plan diversification.
There are restrictions on IRA investments
IRA investment guidelines limit what investments can be made, and disallow “self-dealing” or “prohibited transactions.”
For more information on these guidelines see “The Dos and Don’ts of IRA Investing” by Robert Preston at http://www.aicpa.org/pubs/jofa/apr2000/preston.htm.
Some IRA investments are prohibited, while others are allowed. However, the ones that are allowed generate “unrelated business income (UBI),” which leads to the payment of taxes (UBIT) on that income – even though the investment is made in a tax-deferred IRA account.
IRAs may not invest in life insurance and collectibles (art works, antiques and most precious metals).
Foreign investments should be limited to ADRs and domestic mutual funds.
Real estate investments are allowed, providing your trustee is a qualified provider, he or she allows it and can navigate around complex rules.
When it comes to brokerage accounts, IRAs are “cash accounts” and may not use margin to buy stocks (or other forms of debt-leverage for purchasing stocks). If an IRA invests in a hedge fund or other investment company that uses leverage, that is tantamount to breaking the rule on the use of leverage. The consequence is the generation of UBI from the income in the hedge fund and taxes on that income (UBIT).
In the above article, Robert Preston writes, “With certain investments, IRA owners face other risks. The IRS can use portions of the IRC (sections 511–514) to tax a not-for-profit or a tax-exempt entity that conducts business unrelated to its original purpose. The rules cover income-producing 'businesses' in tax-exempt entities, including trusts (IRA trusts under section 408(e)(1) that are considered businesses). Investments can lose their tax-exempt status and be taxed as business entities even though they operate in a tax-exempt environment. These rules relate only to investments the IRS considers 'profit- producing' and camouflaged by tax-exempt entities such as using IRA funds to buy an interest in a cattle-breeding operation or to invest in a hedge fund that uses leverage to purchase securities. Both transactions generate unrelated business taxable income (UBIT).”
Do you owe taxes if you day trade your IRA?
Many traders are interested in actively trading their IRA accounts, even though they can’t use margin to buy stocks.
Some traders will enter and exit trades on a daily basis, similar to how they operate their day trading business in “taxable” accounts.
This raises an important question of great concern to many traders. Will the IRS consider day or swing trading in an IRA account a camouflaged “profit-producing” activity that is subject to UBIT?
Many traders may not mind paying taxes on their day trading gains in their IRA account, since they would have to pay similar taxes anyway in a taxable account. Their goal may be to tap additional sources of trading capital and they don’t mind losing the tax-deferral benefits. If a trader stops trading, then the future profit growth is tax-deferred in the IRA account.
“Prohibited transactions” and “self dealing” will cost you dearly
The IRS does not allow “self-dealing” or “prohibited transactions” between your retirement-plan assets and yourself.
For example, if you actively trade your retirement-plan assets (ERISA or not), you may not pay yourself a management or administration fee. That will be deemed “self dealing” and be subject to “prohibited transaction” tax penalties. The initial tax on a prohibited transaction is 15 percent.
That’s not your only problem. You also have an “early withdrawal” subject to ordinary taxation plus a 10 percent excise-tax penalty (Form 5329).
Here are other self dealing and prohibited transaction to stay clear of:
Your retirement plan may not be a partner in your trading entity.
You can’t sell securities from your taxable accounts to your retirement accounts.
You and your family members may not invest their retirement plan assets into your own hedge fund.
Based on a more aggressive interpretation of the law, some CPAs and attorneys may not categorize an owner’s IRA investment in their own hedge fund as a self-dealing prohibited transaction, providing the following facts and circumstances apply: The managing member does not earn any revenue from his own IRA (i.e., fees at zero); the IRA capital may not be material enough to help the managing member launch the hedge fund (showing others the fund has other investors of certain magnitude); the IRA does not help pay the fund expenses in a material manner.
Taking this more-aggressive approach may give you the answer you want to hear, but recognize that you may turn your tax-deferred or tax-exempt IRA into a taxable account. We do not suggest this aggressive approach.
Solo traders with ERISA plans are stuck with the 25-percent rule
Traders may raise the following question: "I don’t have any employees
so why should this ERISA plan diversification rule apply to me?"
Tough luck. If you have an ERISA plan the rule applies to you even if you don’t have any employees.
If you trade an ERISA plan that only includes yourself (no employees), you may think "What’s the risk if no employees can sue me for ERISA violations?"
You should also consider that if you get divorced and it’s contested, your spouse’s attorney can allege ERISA violations. A spouse may be entitled to half or another portion of your ERISA retirement plan assets and deserve the protection of ERISA.
A conservative approach to the 25-percent rule
In my prior Active
Trader articles on this subject, “A Special K," February
2003, and "The Proof is in the Return," April 2003, I stated
a conservative approach to the 25-percent rule as advocated by our attorney
who specializes in ERISA and tax law.
Both articles mentioned that traders should only actively trade 25 percent of their ERISA plan assets and conservatively invest the other 75 percent.
Many traders have written our firm and posted questions on popular message boards asking for more detailed information on the 25-percent rule and ways to possibly navigate around it. I explain the rules above and ways to navigate around it below.
Traders and their CPAs looked for the 25-percent rule in the tax code but it's not there. The 25-percent rule is an ERISA rule, not a tax-code rule.
Our retirement plan attorney recommends that traders only actively trade (with risk) 25 percent of their ERISA plan assets. To achieve required plan diversification, she recommends prudently investing the remaining 75 percent in mutual funds, interest-rate and other types of non-stock investments.
Our attorney based her recommendations on research of ERISA and DOL court cases. DOL raised the stock investing argument in a few litigations. However, our attorney’s informal opinion is that ERISA case law supports the following: "a high concentration of plan investments in stocks was prudent for a fiduciary and not an ERISA violation" and "there is support (in the ERISA case law) for day traders to self-direct plan (ERISA) investments."
If there is a will there is a way (around the 25-percent rule).
Consider the following example of trading in an ERISA plan.
This trader is actively trading 100 percent of ERISA plan assets but may not be in violation of the 25-percent plan-diversification rule.
A business trader actively trades 10 stocks on a daily basis and he does not keep any positions overnight (day trading). This trader hedges his positions and monitors risk very closely, using stops and other available methods. This trader is diversified and, notwithstanding the perceived risk of day trading, this trader is consistently profitable.
The spirit of the 25-percent plan-diversification rule calls for risk management, liquidity and diversification. It does not specifically state that active trading is prohibited. It can be argued that this trader is not "buying and holding" one or a few stocks with great market risk. In fact the trader is very diversified and trading with plenty of risk management.
What can be argued as risky is the pursuit of day trading, a known high-risk activity. A profitable trader can argue that consistent profitability proves that day trading is not high risk for them.
Of course this trader may not need to tap into retirement-plan assets; a consistent losing trader may need to tap these retirement-plan assets and hence they may have a problem with this argument.
This more aggressive approach is based on theory and has not been tested under the law, so proceed with caution and at your own risk. Consult with an expert to better assess this risk.
Consider the reverse example: A consistent losing trader actively trades
stocks in his ERISA plan in a very risky manner without the use of stop
losses or hedging. An argument can be made that this trader violated ERISA
rules by not diversifying out of risky swing and day trading activities.
You can’t get trader tax status benefits from just trading your retirement
accounts
Now that you solved how to actively trade your retirement-plan accounts without ERISA or tax trouble, keep in mind that you are still lacking trader tax status unless you actively trade a taxable account as well.
Retirement-plan trading does not count for trader tax status (business tax treatment). You need trader tax status in order to deduct all your trading business expenses.
If you just trade retirement-plan accounts and no taxable accounts, all your expenses are matched to your retirement-plan income, which is tax-deferred; that makes your expenses also tax-deferred. It will be difficult (but possible) to keep appropriate records so that when you retire and take taxable distributions, you can reduce that income by the deferred expenses. An administrator will not allow you to record those tax-deferred expenses in the retirement account.
To protect against deferral of your expenses, achieve trader tax status on at least a small taxable trading account. Within reason, you can allocate all your business expenses to the taxable account and not be stuck with any expense deferral. You will then get the best of both worlds.
Bottom line
If you want to actively trade your retirement-plan accounts, first
determine which EIRSA and IRS rules may apply to your trading plan. It’s
a minefield with gray areas and you need to protect yourself against ordinary
taxation on “unrelated business income” or “early withdrawals,” plus 10-percent
excise tax penalties on early withdrawals, plus 15-percent tax penalties
on “prohibited transactions” on “self-dealing.” Ask yourself is it worth
these extra costs, uncertainties and headaches to put your retirement
(accounts) at great risk? For some the answer may be yes, so do your homework
and try to stay clear of these extra costs and gray areas. Consult with
a CPA and/or tax attorney with expertise in the retirement plan and trading
areas. If you are talking big bucks, it may pay to engage an expert firm
to prepare a file for a private letter ruling with both the IRS and DOL.
No
credit or margin is allowed in retirement-plan accounts, because they
are "cash accounts."
Important update on March 12, 2004:
We point out in our above article that there are several limitations
in trading your retirement accounts such as a business-activity (hyperactively).
Since writing this article, one more significant limitation has arisen
as a result of a recent NASD crackdown on credit abuses in "cash
accounts."
All retirement plan accounts are "cash accounts," whereas business
trading accounts are "margin accounts." Business traders, who
fall under the "pattern
day trader rules" are allowed 4-to-1 margin; investors are allowed
2-to-1 margin. Cash accounts are not permitted any credit or margin. Herein
lies the problem with the recent NASD crackdown.
NASD argues that many brokerage firms are allowing credit in cash accounts,
where no credit is allowed by law. NASD is not claiming brokers are using
margin in cash accounts, but claiming credit infraction over a technicality
– using proceeds for purchases before the proceeds' settlement date.
For example, if you sell a stock and re-purchase another stock before
the first stock sale settles (3 days later), NASD claims your broker is
lending you the funds and that's a violation on cash accounts.
The consequence of this "waiting for settlement date" rule is
that "cash account" holders will have to wait longer to turnover
capital in their cash accounts. This can be a significant problem for
active traders.
WASHINGTON, March 11 /PRNewswire. PRESS RELEASE: NASD Fines Ameritrade,
Datek and iClearing $10 Million for Improperly Extending Credit and Allowing
Trades. Click here to read this story.
A leading brokerage firm recently sent the below e-mail (redacted) to
one of our GTT pros, which explained this policy change on her retirement
account.
E-mail: Thank you for choosing XXCo.
Thank you for your e-mail regarding your buying power. In order to comply with a more strict interpretation of trade settlement regulations, XXCo. has changed its policy towards cash account trading as of 12/19/03.
In a cash account such as yours and for trades placed on our website, all proceeds from a sale will not be available for reinvestment until the trade has settled. However, customers can purchase securities, through one of our brokers, if sufficient funds from a sell order will settle on or before the settlement date of the purchase (system changes will make these trades available on our website in the near future. In the meantime a broker assist fee will not apply). Regular way settlement for stocks is going to be the day of the trade plus three business days, options settle just one business day after the trade, and for mutual funds please consult the funds prospectus. For example, if you sold your stocks on Tuesday, the funds would be available for reinvestment on Friday.
Alternatively, once you sold your stock on Tuesday you would be able
to use those funds for re-investment if you call us at the number below
and one of our brokers placed this trade for you. A broker assist fee
will not apply. If you choose to purchase additional stock through a broker,
please note that this stock cannot be re-sold within the settlement period.
Doing so will result in a free riding violation on your account. Two free-riding
violations in a cash account may result in it being closed. It is your
responsibility not to sell stock that will cause a violation. We understand
that this has changed the fundamental manner in which you are able to
trade within your account and we apologize for the inconvenience and hope
to educate you on the changes.
These cash settlement regulations affect only cash accounts; however,
trading within margin accounts remains unaffected. If you are considering
upgrading your account to margin, please note that there are risks involved
with establishing and using a margin account. Ultimately you would have
to determine whether or not a margin account would be suitable for your
investment objectives. Please note that margin is not allowed on retirement
or custodial accounts.
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here.
IRS Form 5500
ERISA Annual Report: ERISA (retirement) plans must file an annual
report to the U.S. Department of Labor (DOL) each year on Form 5500 or
Form 5500-EZ. These forms are due by Aug. 1 of the following year (2004
Form 5500 is due Aug. 1, 2005).
An automatic 2.5-month extension for filing employee plan returns is obtained
if a properly completed Form 5558 is filed by the due date of the Form
5500 Series return/report. The IRS will not return an approved copy of
the extension request to the taxpayer. The taxpayer must attach a photocopy
of the completed Form 5558 to the Form 5500.
Individual Retirement Accounts (IRAs) are not ERISA plans so no annual
report (Form 5500 or any other form) is required for IRAs (including but
not limited to traditional IRAs, Roth IRAs, SEP IRAs and education IRAs).
ERISA-based plans include but are not limited to 401(k) plans, Mini 401(k)
plans, Keogh plans, profit-sharing plans, money-purchase plans and defined
benefit plans.
Many ERISA plan administrators prepare a Form 5500 or 5500-EZ for their
clients. If not, use the below resources to file the form on your own,
or you can ask our firm for this assistance.
Our tax software (Lacerte) has all these forms, so we can prepare your
5500, 5500-EZ and extension Form 5558. Please contact
us (or your GTT tax preparer) by July 25 if you want us to file your
extension.
One person or husband/wife plans file 5500-EZ. It's fairly simple to prepare
with very basic plan information.
Here are some resources to learn more:
www.irs.gov/retirement/article/0,,id=110293,00.html
www.efast.dol.gov/
– US Department of Labor (DOL) Employee Benefits Security Administration
(Form 5500)
www.dol.gov/ebsa/ – US Department of Labor (DOL) Employee Benefits Security Administration.
(800) 829-3676 DOL toll-free.
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