Avoiding Penalties on Your IRA Investments
Alternative investments are growing in popularity. These include precious metals, real estate, and small businesses. Owning these through IRAs or other qualified retirement accounts could be a good financial move, or it could lead to trouble. Make this move without the right advice and you could fall into one of the many traps in the tax law.
Purchasing some non-traditional investments through an IRA might trigger penalties. Problems are most likely to be encountered with “hard assets,” such as gold, real estate, and other inflation hedges, but there are other traps.
Before buying an investment with your IRA, be sure it passes three separate tests in the tax code: prohibited investments, taxable investments and transactions, and prohibited transactions.
Understanding prohibited investments
The main category of prohibited investments for IRAs, 401(k)s, and other self-directed retirement plans is “collectibles”. When an IRA acquires a collectible, it is treated as making a distribution equal to the purchase price or value. When an IRA pays $10,000 for a collectible in 2011, the owner is treated as receiving a $10,000 distribution in 2011. When the owner is under age 59½ and does not qualify for any of the exceptions to the early distribution penalty, the penalty of 10% of the value of the distribution also must be paid.
Collectibles are art, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages, or any other tangible personal property specified by the IRS. To date, the IRS hasn’t expanded the list.
There are exceptions. Certain bullion coins issued by the U.S. (generally the American Eagle gold, silver, and platinum coins) and any coins issued by any of the states are not collectibles. Also gold, silver, platinum, or palladium bullion are not collectibles when the metal equals or exceeds the minimum fineness required under a regulated futures contract and is in the physical possession of a qualified trustee.
Only physical collectibles are prohibited. Some indirect investments are allowed, such as purchasing securities of firms that produce or deal in collectibles, including securities of precious metals mining companies, art dealers, and producers and distributors of alcoholic beverages.
You can own precious metals through an IRA by purchasing an exchanged-traded fund (ETF) that purchases gold or silver bullion. The IRS ruled privately that when an IRA purchases shares in a bullion ETF organized as a trust, such as SPDR Gold Trust (ticker: GLD) or iShares COMEX Gold Trust (IAU), the IRA is treated as purchasing securities, just as though it purchased shares in any other ETF, mutual fund, or company. There is an exception. Should the ETF distribute its bullion in-kind to shareholders, an IRA owning ETF shares would be treated as acquiring a collectible when the distribution is made.
The prohibited investment rules also don’t apply to ETFs that use futures or derivative contracts to track the performance of metals or metal-based indexes, such as PowerShares DB Gold, PowerShares DB Silver, and Power-Shares DB Precious Metals.
A cousin of the ETF is the Exchange-Traded Note (ETN). ETNs based on the price of bullion or any other collectible are not collectibles. They own no assets, and the IRA has no right to specific assets. The ETN is simply an unsecured debt of the issuer. An IRA may purchase them without being considered to purchase a prohibited investment.
The other category of prohibited investments for IRAs is life insurance. The only life insurance allowed to be owned by an IRA is incidental life insurance benefits that are part of an annuity.
How MLPs Cause Taxes on IRAs
IRAs and other qualified retirement plans generally are not taxed on their investment returns as long as the returns remain in the accounts. Owners pay ordinary income taxes on the returns when they are distributed.
An IRA or other plan might have to pay income taxes, however, on unrelated business taxable income (UBTI). If an IRA earns total UBTI exceeding $1,000 it must pay income taxes on that income. The IRA has to file Form 990-T when gross unrelated business income is more than $1,000. It also must pay estimated income taxes during the year if the adjusted UBTI exceeds $500.
The rules on UBTI are long and detailed, but UBTI generally is income generated by an operating business owned by the IRA. The UBTI rules also apply when the IRA owns any interest in a pass-through business entity (partnership or limited liability company).
Master limited partnerships (MLPs) and real estate partnerships are most likely to trap IRA investors under this rule. MLPs are traded on major stock exchanges, and many people think of them as being the same as corporate stock. In fact, these are limited partnership units, and the income and expenses of the partnerships pass through to the owners’ tax returns. The MLP generates UBTI. The Form K-1 issued by the MLP states the amount of UBTI earned by the IRA.
Also, any type of income becomes UBTI when debt is used to finance the property that generates the income. For example, if an IRA receives a margin loan from its custodian or broker, income generated by the securities purchased with the loan proceeds would be UBTI. A mortgage on real estate also converts exempt income into UBTI. An IRA may 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 and is taxed as earned.
Important note: The UBTI rules also apply to Roth IRAs the same as traditional IRAs.
UBTI on MLP income can be avoided by owning a closed-end fund or ETF that itself owns publicly-traded MLPs.
Spotting prohibited transactions
Transactions between the IRA (or any qualified retirement plan) and its owner or any person closely related to the owner (including businesses) generally are prohibited. But there are exceptions, and you can apply for a waiver even for a transaction that clearly is prohibited. The prohibited transaction rules are a vast and complex body of law. IRA owners need to know only the highlights. If you want to engage in a transaction that might be prohibited, consult a tax advisor who knows the rules.
The penalty for engaging in a prohibited transaction is severe. The entire IRA will be treated as being fully distributed the date the prohibited transaction was made, including any portion of the IRA not involved in the prohibited transaction. When the owner has multiple IRAs, only the IRA that engaged in the prohibited transaction is penalized.
For more details about avoiding penalties on your IRA investments, consider obtaining a copy of my report, IRA Investment Guide: A Road Map for Avoiding the Traps and Penalties for IRA Investments. You can learn more about it in Bob’s Library at www.RetirementWatch.com.
RW November 2011.
