Don't Get A Surprise Tax Bill From Your IRA

You probably know about potential IRA tax traps related to withdrawals, rollovers, and estate planning that can saddle you with penalties and surprise tax bills. Did you know that the type of investments you hold could also hand you a surprise tax bill and potentially ruin your IRA status?

The most common of the traps results in tax bills through Unrelated Business Taxable Income (UBTI). The sources of business income from stocks, bonds, and funds such as interest income, capital gains and dividends are exempt from UBTI and the corresponding tax (unsurprisingly called the Unrelated Business Income Tax or UBIT). IRAs that operate a business, have certain types of rental income, or receive income through certain partnerships, are subject to taxation once the total UTBI exceeds $1,000. The purpose is to prevent tax-exempt entities from gaining an unfair advantage on regularly taxed business entities.

UBIT can take quite a bite out of an IRA. The top tax rate of 39.6% kicks in at approximately $12,000 of taxable income. These tax bills frequently come with penalties because IRA owners are not even aware that the bill exists.

Master Limited Partnerships (MLPs) held within IRAs are a prime example of how UBTI can catch investors by surprise. MLPs are fairly popular investment vehicles, but when they are held within an IRA, they are subject to UBIT. When the tax is due, the IRA custodian must obtain a special tax ID number and file Form 990-T to report the income to the IRS.

The owner is responsible for paying the tax, and is normally unaware of the bill until it arrives as a completed form to be submitted to the IRS — filled out, and signed on behalf of the owner. In some cases, the owner might be required to pay estimated taxes throughout the year as with self-employment income, thus racking up significant underpayment penalties through ignorance of the rules.

Investment Tax Surprises

Among IRA holders who hold investments subject to UBIT, those who get the surprise tax bills may be the lucky ones. Others remain unaware of the tax dangers to come. A recent Wall Street Journal article reported that IRA custodians sometimes do not have sufficient or timely information on K-1 forms from MLPs to fill out their tax return. This happened with around 5,000 late filings from a Kinder Morgan MLP. In other cases, IRA custodians are reportedly unaware of the entire issue. Eventually a tax bill will arrive, with penalties aplenty.

Engaging in prohibited investments will also result in a tax surprise. Competent advisors will steer clear of these, but self-directed IRAs can easily run afoul of the rules. Alternative investments such as artwork, antiques, and precious metals (with a few exceptions) are generally considered as distributions to you and thus subject to taxes.

Prohibited transactions are a step beyond prohibited investments. They can result in the loss of tax-deferred status for your entire IRA. Examples include using your IRA as security to obtain a loan, using IRA funds to purchase personal property, or paying yourself an unreasonable compensation for managing your own self-directed IRA. Executing a prohibited transaction results in the entire IRA being treated as a taxable distribution to you.

The moral of the story is very clear — as with fund holdings, ETFs, and other investments, it pays to know the details of what you own and how to handle the corresponding paperwork. Seek advisors and IRA custodians who are completely versed in the tax laws and can eliminate any nasty surprises.

This article was provided by our partners at moneytips.com