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Are Taxes Lurking in Your Tax-Free Retirement Account?

By Laura Saunders

Wall Street Journal Logo

Investments in items like hedge funds, limited partnerships could lead to surprise tax bill

Fanny Handel, a retiree in Queens, N.Y., was stunned to receive a notice in 2015 telling her she owed $92,000 in taxes on her traditional individual retirement account. Like many Americans, she thought the account was tax-free.

But she was wrong. It is entirely possible to owe tax on a “tax-free” IRA or Roth IRA, even on an allowed investment.

Mrs. Handel’s tax bill sprang from a nontraditional asset in her account—several thousand units of a popular Kinder Morgan master limited partnership. She thought holding them in an IRA would shield her from taxes, but doing so raised her bill after a merger triggered levies for thousands of investors. Her final tax due dropped to $76,000 because of abated penalties and interest, she says.

Taxpayers should beware that as IRAs grow in size, so does the potential for taxes on these accounts if they have investments in alternative assets such as hedge funds, private-equity funds, limited partnerships, operating businesses and real estate.

Some IRA sponsors have stepped up attention to this issue. Fidelity Investments added a system to track taxable income in IRAs beginning in 2016, and the first notices will be going out this tax season, according to a spokesman.

The reason why there are taxes on an apparently tax-free account stems from Congress’s decision decades ago that nonprofits shouldn’t unfairly compete with taxable firms.

This means that if a nonprofit like a university owns a noodle business, then it must pay income tax on the “Unrelated Business Taxable Income,” or UBTI, from its noodles so that taxable noodle companies won’t suffer. (Noodle profits were the issue in a landmark case.) These UBTI rules apply to IRAs, as well as to hospitals and museums.

There is no tax if the IRA has interest, dividends and gains from the sale of stock, which is the income generated by most stocks, bonds, mutual funds, and ETFs.

But the rules do impose taxes when an IRA invests in operating businesses that pass profits and losses directly to the owners, such as partnerships and limited-liability companies. They also can tax IRA income that is debt-financed.

Here’s a simplified example. Say an IRA invests in a building on which there is debt. If the loan equals 50% of the property’s cost at the time, then 50% of the earnings, after deductions, would be considered taxable income to the IRA, says Warren Baker, a Seattle lawyer who advises wealthy investors about alternative assets in IRAs.

As more IRA owners look to invest in alternative assets for accounts large and small, here’s what to know.

--Ask before you invest. The time to find out about UBTI is up front. In general, a risk exists for investments that report results to the Internal Revenue Service on a Schedule K.

Smaller investors could have UBTI if they sink their IRAs into a profitable business. So could IRA owners, like Mrs. Handel, who invest in publicly traded partnerships—especially when units are sold.

Mr. Baker says there is wide variation in offerings to wealthy investors, because some are structured to avoid UBTI and others aren’t. “Sometimes it’s not even clear from the documents,” he says.

--Understand the tax bite. Because UBTI is taxed at trust rates, the top rate of 39.6% kicks in quickly—at $12,500 of income in 2017.

However, each IRA gets a UBTI exemption of $1,000. So if a saver has three traditional IRAs and a Roth IRA, he gets four exemptions.

If there is tax, be sure it is paid with IRA assets. If the account owner pays with outside funds, the entire IRA could become taxable.

--Find out who files. Tax on UBTI doesn’t go on the IRA owner’s individual return. Instead, the IRA must apply for its own taxpayer ID number, file a Form 990-T with the IRS, and pay the tax.

At some IRA providers, the account owner is responsible for the form and can choose a professional to prepare it. This group includes Pensco Trust Co., which is known for holding many large alternative-asset IRAs, and Equity Trust Co.

Others, including Fidelity, Vanguard Group, Charles Schwab Corp. and Robert W. Baird & Co., prepare and file 990-T forms based on documents they receive, and the IRA owner has less to do with the process.

--Figure out fees. Who pays for the preparation of a 990-T? This varies as well. Currently Vanguard, Schwab and Fidelity say they bear the cost of preparing the form they submit.

Baird, which has many accounts with MLP holdings, passes tax-prep costs through to the customer for tax-prep costs, and some other firms do this as well.

To read this article in the Wall Street Journal, click here.