Yes, it’s true. There are times when your IRA can owe tax, even though retirement plans are tax-advantaged accounts. There are two ways your retirement plan can incur tax, and you must be aware of these rules to comply with the IRS. Failure to do so can jeopardize the tax-sheltered status of your retirement savings, and you don’t want that to happen. Read on learn about unrelated business income tax (UBIT) and how certain investments and investment strategies can trigger this tax and what you can do about it. These rules apply to all retirement plans, not just to self-directed IRAs.
Here’s Why Your Retirement Plan May Owe UBIT
1. Your IRA used debt-financing to help purchase an asset. Let’s say that your IRA took out a non-recourse loan to invest in a property. When your IRA sells that property, if there is any outstanding debt owed on that loan, your IRA earns unrelated debt-financed income (UDFI) on the percentage of gains attributed to the debt-financed percentage used to purchase the initial investment. When this is the case, your IRA will owe on the amount of UDFI it earned. Additionally, UBIT may be owed on the debt-financed portion of a rental property that earns income via monthly rental payments from tenants.
2. Your IRA owns a business not housed in a C-corp that generates income. Here again, UBIT may be owed depending on the net income generated by the business asset held in the IRA. So, if your IRA-owned business is not a C-corp, the minute it earns income in the account, that income becomes subject to UBIT. The reason C-corps avoid UBIT is that these entities pay taxes at the corporate rate before paying shareholders (including IRAs) any dividends.
3 Ways to Reduce or Avoid UBIT
1. Don’t use leverage such as a non-recourse loan to invest for your IRA. Instead, consider partnering your IRA funds with your personal funds, with funds of another investor or IRA. This strategy eliminates the possibility of UDFI which triggers tax liability.
2. If you do use leverage to invest, pay it down as quickly as possible from profit gained from other IRA assets. If you can pay off the debt note used for leverage at least 12 months (or more) before you sell the IRA-owned property, you’ll avoid UBIT on any gains from the sale.
3. If you are eligible, use a solo 401(k) to invest. These retirement plans are not typically subject to UBIT from UDFI.
Don’t Let a Potential Tax Liability Prevent You from Investing
Even though paying taxes is never fun, don’t let the above deter you from investing in a business in your retirement plan or using a non-recourse loan to invest. Sometimes, these things are simply the cost of doing business relevant to investments in an IRA. If you find the right asset and it proves to be fruitful—the retirement income you can potentially make far outweighs the tax implications outlined above.
If you have questions or want more information, please contact Advanta IRA today.