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.
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.
Identifying and calculating UBTI/UDFI 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 | firstname.lastname@example.org.