Investors are starting to fall into traps with their IRA investments. The law has had these traps for many years. They are being sprung now because more invest-ors are attracted to nontraditional investments.
Investments in publicly-traded stocks, bonds, and mutual funds don’t pose problems, but purchases by IRAs of some nontraditional investments are prohibited or penalized. Problems are most likely to be encountered with “hard assets,” such as gold, real estate, and other inflation hedges.
To avoid tax problems, your investments have to pass muster under three categories: prohibited investments, taxable investments and transactions, and prohibited transactions.
The prohibited investment rules apply to IRAs and to other self-directed accounts, such as 401(k)s. The main category of prohibited investments is “collectibles”.
The amount used by an IRA to acquire the collectible is treated as a distribution to the IRA’s owner. When an IRA pays $10,000 for a collectible in 2010, the owner is treated as receiving a $10,000 distribution in 2010. 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.
The prohibited transaction penalty can result in double taxation. You include the value of the collectible in gross income in the year the IRA acquires it. Eventually the IRA will distribute to you or your beneficiaries either the collectible or the cash proceeds from selling it. That distribution also will be included in your gross income. There is no credit or deduction for the tax paid on the purchase of the collectible.
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 the physical collectibles are prohibited. Securities of firms that produce or deal in collectibles are allowed, including securities of precious metals mining companies, art dealers, and producers and distributors of alcoholic beverages.
ETFs and Prohibited Investments
Most bullion is prohibited, but what about the shares of 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), the IRA is not treated as purchasing bullion or a share of bullion. Instead, the IRA purchases 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 PowerShares DB Precious Metals. Also avoiding the prohibited investment rules are mutual funds and ETFs that buy the securities of companies in the bullion business, such as gold mining companies.
ETNs and IRAs
A cousin of the ETF is the Exchange-Traded Note (ETN). An ETN is a promise to pay the investor an amount equal to the return of a specific index or other price benchmark, minus the ETN’s fees and expenses.
The ETN is not even a fund that holds investments. It is a promise by the issuer to pay at maturity the amount described in the prospectus. The ETN is a debt of the issuer, such as Barclays. The issuer might or might not buy futures contracts or other securities based on the index to ensure it has sufficient money to pay ETN shareholders at maturity. If the issuer goes bankrupt or is otherwise unable or unwilling to pay its obligations under the ETN, the holder of the ETN is a general creditor of the issuer.
ETN trades on stock exchanges and can be bought or sold any time the exchange is open. The price will be determined by supply and demand for the ETN shares and can trade at a premium or discount to the value of the index.
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 penalty.
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.
Taxable Investments: MLPs other Operating Businesses
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 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 IRA owner essentially will be taxed twice on UBTI. The IRA will be taxed on the income as it is earned. Subsequently, the owner or beneficiary will be taxed on distributions of that income. There is no deduction or credit available to the owner for UBTI paid by the IRA, and the tax paid by the IRA does not increase the tax basis of the IRA.
UBTI generally is income generated by an operating business owned by the IRA. The rules also apply when the IRA owns any interest in a pass-through business entity (partnership or limited liability company).
This rule most often trips up individuals who invest their IRAs in master limited partnerships (MLPs) or real estate partnerships. 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 at tax time. When an IRA’s taxable income from MLPs exceeds $1,000, the IRA must pay taxes on that income, as mentioned above.
Unlike collectibles, ownership of MLPs and other pass-through entities is not prohibited by IRAs. The ownership, however, triggers the UBTI tax and possibly the requirements to file a version of Form 990 and pay estimated taxes.
When an IRA does own MLPs and earns income of more than $1,000 for the year, some tax advisors recommend taking the easier and cheaper route of reporting any IRA-owned pass through income on the IRA owner’s individual tax return instead of preparing a separate return for 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 can be avoided by owning a closed-end fund or ETF that itself owns publicly-traded MLPs.
The prohibited transactions rules generally outlaw transactions between the IRA (or any qualified retirement plan) and its owner or any person closely related to the owner (including businesses). 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 considered fully distributed when the prohibited transaction was made, even the 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.
We discussed the prohibited transaction rules in the June 2004 issue. The article is on the IRA Watch section of the Archive on the web site and still is accurate.
February 2010. RW