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How Your IRA Could Be Taxed (Even a Roth IRA)

Published on: Feb 12 2023

Years ago, a pension plan acquired an interest in a spaghetti factory. A consequence of that episode is that your IRA might owe income taxes on some of its investment income.

Other spaghetti manufacturers said it wasn’t fair they had to compete with a business owner who was tax-exempt.

Eventually, Congress agreed and enacted the unrelated business taxable income (UBTI) rules.

The rules were targeted at situations like the pension plan that owned and operated a business that competed with taxable businesses.

But the UBTI rules were broadly written, so your IRA could be snared in them and owe income taxes on some of its investment returns.

IRAs are more likely to owe income taxes now than they were a few years ago because of the innovations in the investment world and the increased willingness of IRA owners to buy assets other than traditional stocks, bonds and mutual funds.

Both Roth IRAs and traditional IRAs (as well as other retirement plans) can have taxable income. Having money in a tax-free Roth IRA doesn’t keep it safe from this tax.

An IRA potentially has unrelated business taxable income 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 uses debt to finance investments

Fortunately, the tax code specifically excludes interest, dividends, capital gains and profits from options transactions from the definition of unrelated trade or business income.

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.

Interests in master limited partnerships (MLPs) are the most likely source of UBTI for IRAs. An MLP is a pass-through business entity since it’s a partnership. MLP interests trade on the exchanges like corporate stock, so many investors don’t realize they’re investing in something with different tax rules.

There also are a few limited liability companies (LLCs) that trade publicly, and these also are subject to the UBTI rules. It doesn’t matter how small a percentage of an MLP or LLC your IRA owns.

The trigger point for taxes is when an IRA earns gross UBTI exceeding $1,000 during the tax year. Then, the IRA must file a Form 990-T (Exempt Organization Business Tax Return). It will pay taxes on its taxable UBTI at the corporate tax rates.

An IRA also must pay estimated income taxes during the year if the income taxes are expected to exceed $500.

Remember, the IRA is a separate taxpayer. The income tax return is filed and the taxes are paid by the IRA.

The IRA custodian or trustee technically should be responsible for doing this for the IRA. But the custodian often doesn’t receive the Form K-1 that reports the income and so won’t even know about the taxes.

The IRA owner bears the ultimate responsibility and cost of the taxes and any penalties. Most custodians and trustees will charge a fee for performing these services. When your IRA owns MLP interests or has any other source of UBTI, check with the IRA custodian about its policy and practice.

Be sure the return is filed and any taxes are paid. Keep in mind a return must be filed when the gross amount of UBTI exceeds $1,000, even if no taxes are due.

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 filing obligation is triggered.

Also, the $1,000 limit applies to each IRA, not per IRA owner. 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 when the income is distributed. 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 MLP often has its own tax advantages. Deductions for depreciation, depletion, and other factors usually shelter a high percentage of the income distributed by the MLP for the first 10 to 15 years of ownership.

Another way an IRA stumbles into generating taxable income is to use debt to finance investments. Any type of income can become UBTI when debt is used to finance at least part of the purchase price. When an IRA uses a margin loan from the custodian to buy stocks or bonds, dividends or interest generated by the securities become UBTI.

An IRA can own real estate and earn rental income, and that rental income will be tax deferred. When the real estate is financed with a mortgage, however, the rental income becomes UBTI. Sometimes a gain from the sale of an investment is UBTI.

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 the MLPs each year is UBTI. But it’s different when an investment was financed with debt.

A gain from the sale of that asset 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, direct business ownership and ownership of pass-through entities. You can find more details in my reportIRA Investment Guide: A Road Map for Avoiding the Traps and Penalties for IRA Investments.



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