Sometimes people are surprised to find out they owe taxes on investments in their “tax-free” retirement accounts. It’s not common, but pension consultants note that it can happen. While most earnings in tax-advantaged accounts, like IRAs, Roth IRAs, or 401(k)s, accumulates free of taxes, some types of investments within these accounts could qualify as Unrelated Business Taxable Income (UBTI) and trigger a tax bill.
UBTI was originally created to make sure that tax-exempt organizations didn’t have an unfair advantage over taxable businesses like for-profit corporations. So if a tax-exempt organization regularly earns income from a trade or business that’s unrelated to the organization’s tax-exempt purpose, that income could be classified as UBTI and is subject to taxes. For example, if a university runs a pizza restaurant that sells to both students and non-students, that restaurant’s income is unrelated to the university’s tax-exempt mission of education. The university pays the same taxes that another pizza restaurant must pay, so that the university’s restaurant has no competitive advantage.
So, how can this affect your retirement accounts? The Internal Revenue Service considers income from real estate investment trusts (REITs), master limited partnerships (MLPs) and some other entities like limited partnerships or S-corporations to be UBTI. Buying stocks or securities on margin could also be UBTI. Another investment classified as UBTI is debt-financed income. For example, if you used your IRA to purchase a partial interest in rental property while financing the rest, part of any rental income could be subject to taxes.
While these situations are unusual, when they occur, the IRA will have to file an income tax return. That means the IRA will need a federal tax identification number and will be required to file quarterly estimated tax payments while the investment is in place if the total tax for the year is estimated to be more than $500. Generally speaking, any investment that reports results to the IRS with a Schedule K could trigger UBTI.
If you’re considering investing your retirement account’s assets in more than just traditional equities, mutual funds, and exchange-traded funds (ETFs), you should be aware of the UBTI rules. You should seek the advice of a qualified tax professional and/or pension consultant. The Participant EffectSM is a beginning-to-end retirement tool that can help you transition into retirement. For more information, contact us at 1-888-968-9168.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
Retirement Plan Consulting Program and other advisory services offered through LPL Financial, a registered investment advisor. This information was developed as a general guide to educate plan sponsors, but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. In no way does advisor assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations.