Selling covered calls can generate income for two to four times or more the income received from stock dividends. Most investors, however, have the bulk of their retirement savings in some type of retirement account.
Can you sell covered calls in a retirement account? You can sell covered calls in both IRA’s and even a few rare 401K plans in which they are allowed after you get your account approved for options trading.
Let’s look at both IRA’s and retirement accounts structured as 401K’s in more detail with regards to selling covered calls.
Selling Covered Calls in a Retirement Account
Whether or not you can sell covered calls in your retirement account depends on what type of account you have.
Selling Covered Calls in a 401K
While 401K’s prohibit the use of margin and trading naked options, you can sell covered calls if you ‘rollover’ your self-directed 401K. Furthermore, you can make the switch without having to leave your employer.
Not only this, but a few rare 401K’s set up for advanced investors, as well as many 401K’s used by sole proprietors, or Solo 401K’s, allow covered call selling. (1.)
Selling covered calls with an IRA, however, is much more common.
How to Rollover 401K to Allow for Selling Covered Calls
To ‘roll’ your 401K assets into an Individual Retirement Account (IRA), follow two simple steps:
- Transfer your 401K assets into an IRA (tax-free and without penalty when done correctly)
- Convert the IRA into a Roth IRA
Be sure to check with your CPA, employer and or breakage firm to ensure you are doing this in the most tax efficient way.
Selling Covered Calls in an IRA
Remember, with a Traditional IRA, you contribute pre-tax dollars, or income you have not yet paid taxes on. Your assets grow tax-deferred and withdrawals are normally postponed until after you turn 59 ½.
The good news is that you can sell covered calls inside a traditional IRA as well as a Roth IRA. The subsequent tax consequences upon withdrawal, however, are different.
Unlike the traditional IRA, with a Roth IRA, you fund your account with after tax contributions and your assets grow tax free. Moreover, withdrawals after the age of 59 ½ are also tax-free.
How Do Covered Calls Work Inside a Retirement Account?
Selling covered calls inside a retirement account works just like they do in a regular account with one important rule; the stock must be purchased before the call option is sold. If this weren’t the case, you’d be “naked” the option, even if only for a few minutes. This is prohibited in a retirement account.
Technically, covered call strategies involve selling a call option on a stock already owned. Having sold hundreds of covered calls over the years, however, sometimes when placing covered call trades, I’ve sold the option just before the stock is bought; this occurs for various reasons, but usually it is because there is an opportunity to get a better order fill on the option at a given moment.
While it can sometimes be a little tricky to always buy the stock first, especially with managed covered call positions, it’s easy enough to work around. If you forget, no worries; you won’t be allowed to place a trade selling call options against stocks you do not yet own.
It’s also worth noting that many investors sell out of the money covered calls on large stock positions they have owned for years, just to bring in another half percent or so return each month. While half a percent may not sound like much, when the S&P 500 yields about 1.7% in dividend income, getting another 6% a year income above the dividend, without any increase in capital risk, is truly a game changer for growing money inside retirement accounts.
Refresher for Selling Covered Calls
If you’re new to selling covered calls, you might be confused by now. Here’s a quick refresher on how covered calls work, regardless of whether it’s outside or inside a retirement account.
It works like this: when you purchase a stock, you can sell a call option on that stock to generate extra income. This obligates you, the call option seller, to sell your stock at a set price on or before the option expiration date. Why go to all this trouble and risk having to sell your stock at a set price? When compared to a a dividend, your income potential is much greater.
Because the increase in the value of the call option (that you’ve sold) is offset by the increase in the value of the stock, your option position is fully protected.
Moreover, you can only lose money if the stock price declines. And even if this were to occur, your overall net loss is still lower due to the income earned from selling the call option.
Is it Efficient to Sell Covered Calls in a Retirement Account?
From a risk perspective, selling covered calls is an extremely conservative option strategy. Therefore, it is efficient in that your risk is only as much as the risk that already exists from owning stocks.
There are, however, some issues with regard to retirement account, or IRA rules, as well as taxes, that affect cash flow efficiency.
First, the point of selling covered calls is to increase income. If the income gotten from selling call options is trapped inside an IRA, it does little good in contributing to monthly expenses for someone seeking to live off investment income. A workaround occurs when an investor is old enough to be able to withdraw from the IRA without penalty. The withdrawal can, in essence, be made up of covered call income; I have done this myself.
This only works up until the point that covered call income reaches the retirement withdrawal amount, of course. Covered call income over the amount of the required withdrawal remains “trapped” inside the IRA. The positive flipside of this perspective is that the IRA has significantly increased income from selling covered calls over the amount it would have made from dividends alone. That income can be reinvested into selling more covered calls, tax free or tax deferred.
How to Sell Covered Calls in a Retirement Account
In order to begin selling covered calls, you’ll need to take a few steps as explained next.
Getting Approval to Sell Covered Calls in Your Retirement Account
To sell covered calls in your retirement account, you have to set up a ‘Limited Margin Account.’
For context, a Limited Margin Account allows you to trade with unsettled funds that would otherwise trigger a good faith violation. This dynamic is essential, because if you incur three good faith violations within a 12-month period, your account can be restricted for 90 days.
Once your application is approved, you need to contact a representative of your brokerage and ask them to transfer your positions to the margin account. This ensures that future trades will default to the margin account rather than your cash account.
Next, you’ll need to get approved to sell options in your account. This involves completing a simple form from your brokerage firm. Note that covered call writing is the first and easiest level for option “trading” approval. There are four levels of options trading at most brokerage firms; the riskier the option trade, the higher the approval needed.
Once this is done, you’re all set up for selling covered calls in your retirement account.
Selling covered calls in your retirement account is an effective way to enhance returns. Just remember, there is risk in owning stocks, period. For this reason, all stock holdings should be part of an holistic wealth plan that defines the investment return needed to reach your financial goals and your acceptable risk tolerance.