Avoiding Taxes on Your IRA
Yes, your IRA could be hit with income taxes, even if it’s a Roth IRA. This is nothing new. The potential for an IRA or other qualified pension plan to owe taxes has been in the law for a long time. It hasn’t affected many investors, because it is only in the last few years that many investors sought investments other than traditional stocks and bonds and related mutual funds.
Keep in mind that an IRA is a separate taxpayer and is subject to different rules than you are. Most of the time IRAs are tax-exempt and have more favorable rules than you do, but there are a few exceptions.
The trap IRAs are most likely to fall into is what the tax code calls unrelated business taxable income (UBTI). When an IRA earns gross UBTI exceeding during a year $1,000, it must file a Form 990-T and pay income taxes at the corporate tax rates. An IRA also must pay estimated income taxes during the year if the tax is expected to exceed $500. The return is filed by and the taxes are paid by the IRA, not by the owner or beneficiary, and the custodian or trustee of the IRA is supposed to be responsible for filing the return and paying the taxes from the IRA. But the custodian might not receive the Form K-1 reporting the income or might not file the return. As the IRA owner and beneficiary you ultimately bear the cost of any taxes and penalties, so be sure to check with your custodian and coordinate who will file the form and pay the taxes. Most trustees and custodians will charge for filing the return.
The $1,000 limit applies to the IRA, not to each investment in the account. If all the UBTI earned by the IRA during the year exceeds $1,000, the tax obligation is triggered. Also, the $1,000 limit applies to the IRA, not per taxpayer. When you have more than one IRA, each IRA has its own $1,000 UBTI limit.
You want to avoid UBTI, because the IRA owner essentially is taxed twice on it. The IRA will be taxed on the income. Subsequently, the owner or beneficiary will be taxed on distributions of that income. No deduction or credit is available to the owner for UBTI paid by the IRA and the tax is not added to the tax basis of the IRA.
An IRA potentially has UBTI if it does any of the following:
* operates a trade or business unrelated to its tax-exempt purpose,
* receives certain types of rental income,
* receives certain passive income from a business entity it controls,
* invests in a pass-through entity, such as a partnership, that conducts a business, or
* uses debt to finance investments.
Any business is considered unrelated to the exempt purposes of an IRA or other retirement plan. Fortunately, the tax code specifically excludes from the definition of trade or business income interest, dividends, capital gains, and profits from options transactions. Royalties also are generally exempt. Some types of rent are exempt; others aren’t.
Controlling a business entity can convert exempt income into UBTI. When an IRA has greater than 50 percent control of a business entity, rent, interest, or royalties paid by the entity to the IRA generally are UBTI.
An IRA is most likely to run afoul of the UBTI restriction when it owns an interest in a pass-through business entity (partnership or limited liability company), because income from these entities is UBTI even if the IRA doesn’t own a controlling interest. Master limited partnerships (MLPs) most often trip up IRA owners.
MLPs are traded on major stock exchanges, and many people think of them as being the same as corporate stock. In fact, these are partnership units, and the income and expenses of the partnerships pass through to the owners at tax time. Owners receive K-1 statements each year instead of 1099s to use in completing their tax returns. The K-1 states the amount of UBTI and other income and expense items attributable to the IRA.
Individuals generally are urged not to purchase MLPs through IRAs, but it isn’t illegal to own an MLP through an IRA. Owning an MLP through an IRA or other qualified plan is discouraged because of the potential for the IRA to be taxed and have to incur the expense of filing different tax returns.
Owning an MLP through an IRA creates UBTI and possibly the requirement to file a Form 990, pay taxes, and pay estimated taxes during the year. Once the $1,000 income threshold is crossed, there is no tax advantage to owning MLPs through an IRA. (When MLPs generate more than $1,000 of UBTI in an IRA, some tax advisors recommend taking the easier and cheaper route of reporting any IRA-owned pass through items on the individual tax return instead of taking the time and expense to file a separate return for the IRA. It’s not clear this satisfies tax code requirements, and if you choose this route be sure your custodian is not also filing and paying the taxes from the IRA.) Also, remember that UBTI is taxed at corporate rates, not individual rates. That makes holding a large amount of MLPs in an IRA unattractive.
There is another reason to make MLP investments outside of a tax-deferred or tax-free account. Most MLPs already have tax advantages. Their operations generate depreciation deductions or other write offs that make a high percentage of income distributions tax free. These tax benefits are diminished when the MLP is owned inside a tax-favored account. (Though the tax advantages of owning an MLP outside an IRA can diminish after an MLP is owned for about 10 years or so.)
Another time an IRA is very likely to have UBTI is when debt is used to finance investments. Any type of income can become UBTI when debt is used to finance the property that generates the income. For example, if an IRA receives a margin loan from the custodian or broker, income generated by the securities purchased with the loan proceeds would be UBTI. An IRA can own real estate and earn rental income, and that rental income will be tax deferred. If the real estate is financed with a mortgage, however, the rental income becomes UBTI.
What about when an investment that generated UBTI is sold? Suppose, an IRA has a substantial investment in master limited partnerships that generated a few thousand dollars of UBTI each year. The IRA sells the MLPs at a gain. Is the capital gain UBTI? No. Only the business income generated by an investment is UBTI. Any capital gains from selling that investment are not UBTI.
When property that was financed with debt is sold, however, the capital gain from that sale is taxed as capital gains to the IRA. If the MLPs were purchased with margin loans, for example, the capital gains would be UBTI.
The UBTI rules are broad and extensive. You have to be especially careful of debt-financed investments, business ownership, and ownership of pass-through entities. You can find more details in my report IRA Investment Guide: A Road Map for Avoiding the Traps and Penalties for IRA Investments. It’s available through the Bob’s Library tab at www.RetirementWatch.com.