More investment choice is not the only reason people save for retirement in a self-directed IRA. IRAs also provide numerous tax benefits to savers – either now or in retirement, depending on whether the self-directed IRA is a Traditional IRA or Roth IRA. To make sure the tax benefits of a self-directed IRA are preserved, IRA owners must properly track their IRA contributions and withdrawals with their annual income tax returns each year. Here are the basic rules for self-directed IRA tax reporting.
Is a self-directed IRA tax-deductible?
Most self-directed IRA owners contributing to a Traditional IRA intend to take a tax deduction for their contributions. This is done each year with their federal income tax return. If the IRA owner does not qualify for the tax deduction, that year’s contribution becomes a nondeductible contribution, or basis, in the IRA. Tax on investment growth inside the IRA is typically deferred until the assets are withdrawn from the IRA. Each IRA withdrawal consists of a pro rata portion of deductible and nondeductible contributions and earnings, based on all of an IRA owner’s Traditional, SEP and SIMPLE IRA balances combined. Any basis included in an IRA withdrawal is not taxable.
IRA owners include the taxable portion of the withdrawal with their taxable income for the year. Ultimately, the amount of tax owed on an IRA withdrawal will depend on the IRA owner’s total tax liability for the year and any tax withholding that has already been submitted (e.g., paycheck withholding, or elected withholding on an IRA withdrawal).
How is a self-directed Roth IRA taxed?
A Roth IRA only accepts after-tax contributions, so no tax deduction is available. Since tax has already been paid on all Roth IRA contributions, they are not taxable when distributed. Investment growth within the Roth IRA accrues tax-deferred, as with a Traditional IRA. If the Roth IRA owner meets the requirements for a “qualified distribution” when they take money out of the Roth IRA, however, the investment earnings will be distributed tax-free, making the entire withdrawal tax free. If a non-qualified distribution is taken, all after-tax contributions are deemed to be distributed from the Roth IRA first, so the distribution would still be tax-free until the IRA owner removes the taxable investment earnings. These Roth IRA tax rules allow IRA owners more time to meet the qualified distribution requirements before the earnings are withdrawn.
Is there an additional tax on IRA distributions?
The self-directed IRA rules include an additional 10% early distribution tax on IRA withdrawals taken before an IRA owner reaches age 59½. This additional tax will be assessed on the taxable portion of the withdrawal, unless the IRA owner meets one of the IRS-approved exceptions (e.g., disability, higher education expenses).
What tax forms need to be filed?
The key to preserving the tax benefits of a self-directed IRA is diligent tracking of contributions and distributions. For example, IRA owners should keep track of any nondeductible contributions made to a Traditional IRA. Similarly, Roth IRA contributions and distributions must be tracked to be able to determine when all contributions have been distributed and the IRA owner is withdrawing investment earnings.
IRA custodians will send IRA owners a copy of Form 1099-R by January 31 to report any distributions made from their IRA for the year. Custodians also send a copy of Form 5498 by May 31 to report all contributions made to an IRA for the year. The IRS matches up the information reported on a taxpayer’s income tax return with the Forms 1099-R and 5498 it receives directly from IRA custodians to determine if any tax is due or unreported.
Two IRS forms you may need to generate and file with your tax return include:
- Form 8606, Nondeductible IRAs, is filed when an IRA owner made a nondeductible Traditional IRA contribution for the year, previously made nondeductible contributions and took a withdrawal during the year, or converted Traditional IRA assets to a Roth IRA. Form 8606 is also filed when an IRA owner takes a Roth IRA distribution.
- Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, is filed to pay the 10% additional tax on a withdrawal taken before age 59½, or to claim an exception to the tax.
Does a self-directed IRA file a tax return?
IRA owners generally claim tax benefits and pay tax associated with a self-directed IRA with their income tax returns. However, there is a situation in which an IRS form must be filed on behalf of an IRA. If a self-directed IRA investment is deemed to generate income that is not substantially related to the tax-exempt purpose of an IRA (saving for retirement), that income may be taxable in the year it was earned. This is called unrelated business taxable income (UBTI) and unrelated debt-financed income (UDFI). If an IRA-owned trade or business has $1,000 or more of UBTI/UDFI in a year, the income is taxable to the IRA in the year it is earned. UBTI/UDFI tax must be paid each year from the IRA holding the investment. The tax is reported to the IRS on Form 990-T, Exempt Organization Business Income Tax Return, on behalf of the IRA by April 15 each year. Typically, the IRA custodian files the return on behalf of the IRA.
As a self-directed IRA owner, you may want to seek professional tax advice to ensure you are claiming and tracking your IRA contributions, distributions, and investment growth appropriately with your tax returns.