To maximize retirement savings accumulations, many IRA owners are turning to “non-traditional” IRA investments, such as real estate, Limited Partnerships (LP) and Limited Liability Companies (LLC). With the potential for increased returns as compared to more traditional investment alternatives, these investments also have the potential for current taxation on earnings. Investment earnings within an IRA are typically taxdeferred until assets are distributed. However, if an investment is deemed to generate income that is not substantially related to the tax-exempt purpose of an IRA (i.e., saving for retirement), that income may be taxable in the year it was earned. This commonly occurs when an IRA is invested in a business, for example. Without these tax rules, a business operating within a tax-deferred environment, such as an IRA or other tax-exempt entity, would have a competitive advantage over a business that is paying taxes on its business income.
What Is UBTI?
UBTI refers to the gross income generated from business activities that are not directly related to the primary purpose of a retirement plan or a nonprofit organization. Under the Internal Revenue Code (IRC), UBTI is subject to unrelated business income tax (UBIT), which can significantly affect your tax liability.
UBTI arises when retirement plans or tax-exempt entities engage in errant business activities or unrelated trade activities. This income can include earnings from investments in master limited partnerships, real estate investments, or other business ventures that do not align with the organization's core mission. While passive income like dividends, interest, and capital gains are generally exempt from UBTI, there are exceptions. For example, rental income from real property may be considered UBTI if the property is subject to acquisition indebtedness or if it involves active business activities.
Tax Implications and Tax Liability
For retirement plans and taxpayers with UBTI, the Internal Revenue Code mandates that this income be subject to federal tax. The applicable tax, known as UBIT, applies to the gross income generated from unrelated business activities. Business owners and plan administrators must report UBTI and make the necessary tax payments within the specified tax year. It's important to note that UBTI can impact the overall tax-exempt status of a retirement plan, potentially leading to a higher tax liability.
There are two types of taxable income within an IRA:
If an IRA has $1,000 or more of UBTI/UDFI in a year, the income is taxed in the year it is earned (rather than tax-deferred until distribution). UBTI/UDFI is taxed at trust tax rates, which are generally higher than individual tax rates. The tax must be paid from IRA assets and may not be paid by the IRA owner. The IRA must file IRS Form 990-T, Exempt Organization Business Income Tax Return, by April 15 of the following year.
How UBTI Affects Retirement Plans
Retirement plans, including those with tax-exempt status, can be affected by UBTI if they engage in business activities that generate taxable income. For instance, if a retirement account invests in a master limited partnership or real estate investments that produce rental income, this income may be considered UBTI. Additionally, any acquisition indebtedness linked to these investments can further complicate the tax implications.
Reporting UBTI
Taxpayers and educational organizers must be diligent in reporting UBTI on their tax returns to avoid penalties and ensure compliance with the IRC. The due date for filing UBTI-related tax returns typically aligns with federal tax deadlines. To accurately determine the UBTI, retirement plans must consider all forms of investment income, including business activities, rental income, and capital gains, and assess the impact of any acquisition indebtedness.
For additional information on UBTI and how it may affect your retirement plans or nonprofit organization, it's advisable to consult a financial advisor or review the relevant sections of the Internal Revenue Code. Understanding UBTI and its tax implications is essential for safeguarding your retirement income and maintaining compliance with applicable tax laws.
Identifying and calculating UBTI tax due is complex. You may want to seek the assistance of a tax advisor if you are investing in an alternative investment that might generate UBTI or UDFI.
To learn more about how UBTI/UDFI may affect your IRA, contact Mainstar Trust: 1-800-521-9897 | customerservice@mainstartrust.com.