Introducing Potential IRA Tax Issues Q & A

Last update on: May 28 2020

By Bruce Miller

After providing a list of applicable rules and some basic information about taxation of IRA withdrawals in my previous article, I will answer a few questions that I encountered while dealing with real customers. I will attempt to relate specific cases and provide guidance of what IRA owners can do if they find themselves in a comparable situation.

At the advice of my investment advisor, I invested in two Master Limited Partnerships (MLPs) two years ago in my Traditional IRA (TIRA). These have done quite well. However, I just received notice from my IRA custodian that I must send them a copy of the K-1 for each of these MLPs. Why are they doing this? Did they lose their copies?

IRA custodians and brokerages do not get copies of K-1s, even though the brokerage offers them as investment choices and is responsible for paying any Unrelated Business Tax (UBT) from an IRA that incurs it. Remember, MLPs are true limited partnerships, Therefore, the dealings and informational transfer occurs directly between the General Partner and the limited partners, and unlike shares of stock or mutual funds, does not first pass through the brokerage.

MLPs are tax-challenging. Even though MLPs trade on the major stock exchanges, you should not invest in units of a MLP unless you fully understand their tax issues.

This last year I bought a stock in my TIRA that lost 80% of its value. Is there any way to take this loss on my income tax?

Unfortunately, no. You did not pay taxes on the pretax dollars in your IRA and a reduction in their value does not constitute a taxable loss. You could take the loss if all your TIRAs, plus any SEP or SIMPLE IRAs – excluding inherited IRAs and RIRAs – are worth less than the after-tax amount of all combined past non-deducted contributions. If you withdraw all money and close the accounts, then the difference between the after-tax contributions and the market value when closed out will represent a loss that you can take only as an itemized miscellaneous deduction subject to the 2% of the Adjusted Gross Income (AGI) threshold. (note: this deduction has been repealed in the Tax Cuts and Jobs Act of 2017 effective for years beginning in 2018.

I am leaving my current employer at the end of this month and I just received a notice that my 401(k) has over 2,000 shares of my employer’s stock, which I accrued over the past 8 years. When the employer contributed these shares as a matching contribution to my contributions, the value of these shares was $32,000 and today they are worth about $61,000. The notice instructed me that I can exercise a Net Unrealized Appreciation (NUA) option for a possible tax favored treatment of the stock, rather than selling them back to the employer – a private company – and then rolling over the proceeds to my TIRA. I do not understand what this means. Can you help?

Certainly. Net Unrealized Appreciation allows you to transfer the employer stock in the 401(k) to your own taxable brokerage account and treat the gain – the NUA – as a long-term capital gain, which will usually have more favorable tax terms when sold. You must declare the “basis” of the stock – the $32,000 in your case – as ordinary income that year. Please note that in the case of private stock, your employer will most likely place restrictions on further transference of the shares other than back to the employer when you elect to sell them. You must transfer anything else in the retirement plan to your TIRA by the end of the year. To determine whether this would be worth it, compare the tax you would pay on the $32,000 that you must declare as income for that year to the tax savings you would get by selling the stock and paying capital gains tax. To make this comparison, you would need to know your Federal and State income tax rates and the tax rate on the capital gains. If you are having trouble with this calculation, your CPA or Certified Financial Planner™ will be able to assist you.

I would like to hold Master Limited Partnership units in my TIRA, but I am still a bit confused by the tax problems. I read the primer on the Publicly Traded Partnership’s website and I understand that when I sell the MLP units, part of my gain will be capital gains and part will be ordinary income. Will I have to pay income tax on these gains when they are sold in my IRA? Additionally, will there be any Unrelated Business Taxable Income (UBTI) issues when I sell these units. Can you explain?

Certainly. Any gains on a sale in the IRA are not taxed until future withdrawals are made. At that time, all distributions that are not a return of the IRA’s basis will be taxed to you as ordinary income. There are no exceptions to this.

The potential issue of UBT at sale will come from the recapture of what is called Sec. 1245 depreciation. If this recapture amount, plus any other MLP income for the year in which the IRA exceeds $1,000, the IRA custodian will be required to pay the UBT, not you. When you sell the units, the MLP itself will send you a statement that shows how the gain you realized is broken out and what part of it is the Sec. 1245 recapture. If there is a UBT, you must send this to the IRA custodian who will complete a form 990-T and submit it along with the tax payment from your IRA to the IRS. The calculation of the UBT is a complicated one and many IRA owners will seek the assistance of a tax professional to understand how it works.

One of the benefits I get for holding MLP units in a taxable account is that most of their distributions are return of capital and are not taxed as income to me. If held in an IRA, would this return of capital that the IRA receives remain untaxed when I make a withdrawal eventually?

No. All distributions from a TIRA, except for basis – after tax contributions – are taxed as ordinary income, and the return of capital does not form a basis in the IRA. This is one of the disadvantages of holding MLP units in an IRA.

When our father died several years ago, my siblings and I became the beneficiaries of his large TIRA. We were told that the mandatory distributions we received each year would be eligible for the Income in Respect of Decedent (IRD) deduction. I understand that it is a deduction, but I do not know where it came from and the accountant handling the estate administrator did not seem to understand it very well. The estate administrator always told us to see a tax professional. Can you explain it?

Yes. This applies in cases where a large estate is subject to an estate tax and an untaxed inherited asset, such as a TIRA, is inherited by the named beneficiaries. In such case, each mandatory distribution to the beneficiaries must be included as ordinary income. This means that the taxed portion of the inherited TIRA distribution – which for most inherited TIRAs is all of the distribution – will have been taxed twice. First, the estate pays the estate tax on the taxed portion of the inherited TIRA distribution. Second, the IRA beneficiary pays taxes again when reporting the taxed portion of the inherited TIRA distribution as taxable income.

To remedy this, beneficiaries may deduct that part of the value of the estate that was subject to estate tax, which represents an IRA’s value when the beneficiaries receive their annual distributions. However, this works only until the beneficiaries receive as a deduction the dollar value of the estate tax caused by the TIRA. I will use an example to clarify how this works.

Assume that the IRA was responsible for 29% of the estate tax paid and that this represents an estate tax of $90,000. As mandatory distributions are made to the beneficiary(ies), each beneficiary will receive a proportional deduction to take on his or her personal tax return as a miscellaneous itemized deduction and which are NOT subject to the 2% of AGI threshold. This continues each year until all of the $90,000 worth of deductions have been distributed. However, each beneficiary must itemize his or her deductions to get a tax benefit from this. The beneficiaries can not benefit from IRD if they do not itemize deductions.

If I make my TIRA contribution for 2017 in 2018 (prior to April 15), will I deduct this contribution on my 2017 tax return or my 2018 tax return?

Your 2017 tax return. Normally, the IRS requires the reporting of income or deductions in the year they are actually made. However, a deductible TIRA contribution is an exception. If you make the deductible TIRA contribution prior to April 15 and you designate it to the custodian as being for 2017, then it will be reported as a deduction on your 2017 income tax return even though the contribution was made in 2018.

Note that you must report conversion contributions – converting part or all your TIRA to a RIRA – in the year of the conversion and cannot be done between Jan. 1 and April 15 of the next year for the previous year.

I have heard that I can make a withdrawal from my TIRA in December, have the IRA sponsor send all of it to the IRS and I will not have to make quarterly estimated tax payments. Is this true?

Yes, it could be. The IRS considers any tax withholdings from TIRA withdrawals to have been withheld evenly over the year. Let us assume that your tax bill for the year will be $10,000. You can withdraw the lesser of at least 90% of this amount – $9,000 in my example – or 100% of the previous year’s tax bill, from your TIRA in December and have 100% of it sent to the IRS. In that case, you would not have to pay quarterly estimated tax payments. However, you must include this December withdrawal in determining your tax bill for the year.

I hope that my answers to the situations described above will help IRA owners navigates the tax code and avoid all potential pitfalls when handling taxation of their IRA withdrawals. I have advised on several occasions that IRA owners should consult a financial professional to ensure adherence to all rules and regulations governing IRAs. The same advice applies when dealing with taxation issues. In my next article, I will provide some basic guidance about naming beneficiaries and ensuring a smooth transition at the death of the IRA owner.