As you invest over the course of years and decades, you become exposed to new types of investments, new investing terminology, and lesser-known investment concepts. One of these less common investment techniques is that of using leverage.
What is Leverage? In the simplest terms, leverage is borrowing money in order to invest it. Borrowing money incurs fees and expenses, of course, so the idea behind using investment leverage is that the amount you’re able to make from the investment you purchase with borrowed funds exceeds whatever you pay to borrow those funds.
Types of Leverage. As you might imagine, there are different types of leverage that individuals use in the hopes of boosting their investment returns. For example, if you have been approved for this type of investing activity, your taxable investment account (such as one you might have at a discount broker) will permit you a certain amount of leverage (borrowing) based on the existing holdings within your account.
Exchange traded stock options are another example of leveraged investing. A stock option gives the holder the right to buy (or sell) a particular number of shares at a predetermined price within a specified time frame. Each stock option contract trades at a fraction of the cost of the underlying stock, so an investor can benefit from the price movements (if he or she chooses correctly) of a given stock much more by using options compared to owning the stock itself.
There are also ways to benefit from investment leverage indirectly, such as by purchasing shares of a mutual fund or other investment pool that utilizes leverage for its own investment activities.
IRA Consequences of Leverage. The legislation that authorizes IRAs as a tax advantaged retirement savings vehicle contains a number of limitations and restrictions on their use. In general, funds within an IRA can only be used for specified purposes (namely, investing for retirement), and borrowing money is not one of those specified purposes. This is true even if the proceeds of the borrowing are used for retirement investing. Taking out a loan within your IRA will result in Unrelated Business Taxable Income (also known as Unrelated Debt Taxable Income), which greatly reduces the tax benefits of your account.
Borrowing to Purchase Real Estate. A reduction in these tax benefits can be significant, but it shouldn’t necessarily be the deciding factor in your investment decision. Some retirement savers still find it worthwhile to take out a mortgage to purchase real estate within their self-directed IRA, despite the tax implications.
Stock Options and Similar Securities. As noted above, you don’t need to borrow money in order to obtain leveraged investments within your account. For example, with publically traded stock options are many different strategies available, and it’s possible to create an options position to represent virtually any type of investment exposure that you desire. Regardless of whether you believe a particular company’s security, or even the market in general, is going to rise, decline, or stay relatively flat over a particular period of time, there is an options position you can take in order to reflect that outlook.