Can You Buy Penny Stocks in an IRA?

It is possible to buy a penny stocks inside a individual retirement account (IRA). Apart from life insurance and collectibles such as works of art and coins, the Tax Service (IRS) imposes few limitations on the types of assets an IRA can hold.However, penny stocks are generally quite risky, so this investment choice should be made with caution.

Penny Stocks

The term penny stock is subjective. The Securities and Exchange Commission (SEC) refers to penny stocks as securities issued by companies with small market capitalizations. These stocks are usually (but not always) traded over-the-counter, such as on the Over-the-Counter Bulletin Board (OTCBB).

For some, a penny stock is literally one that trades for pennies i.e. less than $1. For others, a penny stock is a stock that trades for less than $5. Some consider penny stocks to be any security traded outside of a major exchange such as the New York Stock Exchange (NYSE) or the Nasdaq.

Penny stocks are considered risky and speculative. They often suffer from a lack of liquidity, which translates into a large bid-ask spreads. In other words, the lack of liquidity means it can be difficult to buy and sell because no market participant may be willing to trade the stock at the time. As a result, a wider spread is built into the broker’s bid and ask (or bid and ask) prices. Additionally, penny stocks are subject to fewer registration and regulatory requirements. It is often difficult to obtain reliable information on corporations to properly value them.

IRA Investing in Penny Stocks

Some IRAs allow you to invest in penny stocks. In these cases, a person is most likely working with an IRA trustee who allows client funds to be invested in stocks traded on the OTCBB or Pink sheets.

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There are a number of brokers with IRA accounts that allow penny stock investments. Among the most popular are E-Trade and TD Ameritrade.  Although a self-directed IRA can be used to buy penny stocks, it is generally considered more sensible to use brokerage IRAs. Low transaction fees are a must for penny stock investors and should be considered when selecting a broker.

High risk investment

Although penny stocks look nominally cheap, they carry substantial risk. Investors need to decide if penny stocks really fall within their risk tolerance and whether it is a good use of retirement funds. A risk reduction option before trading a penny stock is to ask the broker if the stock is DTCC eligible.

The Custody Trust and Clearing Corporation (DTCC) is responsible for securities clearing for brokerage houses. If a stock has some type of restriction or is not eligible for DTCC, it usually indicates that it will be extremely difficult for an investor to sell shares of the stock after buying them. Lack of DTCC eligibility also usually means significantly higher trading fees for buying or selling a stock.

Anyone considering using an IRA account for penny stock trading should do due diligence and make sure it is an appropriate investment strategy.