Tax-advantaged individual retirement plans provide opportunities for long-term financial success, but sometimes offer surprises. There’s a misconception that distributions are the only taxable events inherent to retirement funds, though others may exist as well. Taxable income and income tax can occur INSIDE your self-directed IRA or 401(k) and must be paid from the account itself.
Depending on the investment, your retirement plan may owe unrelated business income tax (UBIT). You may receive a Schedule K-1 (Form 1065) for your IRA or 401(k) if income from the previous year was potentially subject to UBIT. Individuals or investment entities may mistake a Schedule K-1 for a simple reporting document like a Form 5498. As a result, self-directed investors may not fully understand the implications of receiving the form and may disregard the Schedule K-1 altogether.
To avoid the potential repercussions of unpaid UBIT, it’s important to understand the information provided on the Schedule K-1 document. Per this information, you may be required to complete a tax filing via Federal Form 990-T.
If there’s a positive figure in this box, your IRA or 401(k) will owe UBIT on the specified amount at the current trust rate. This operating income wasn’t taxed at the corporate level, so your retirement plan will be responsible for paying those taxes in turn.
Unfortunately, you can’t always tell what portion (if any) of your retirement income is subject to tax. UBIT applies if your plan yielded income from debt-leveraged real estate, which may not show on the Schedule K-1. A number in Box 2 means you should contact your investment management team to find out which portion of the indicated figure is subject to UBIT. You may not owe UBIT on the full figure, as the taxable amount will depend on the debt-to-equity ratio of your plan’s real estate holdings.
This box will show rental income in a similar manner to Box 2, except these earnings won’t be related to real estate. This rental income is not exempt from income tax for retirement plans, so your account will be responsible for paying tax on any non-real estate rental income. For instance, if your IRA or 401(k)-held investment rents out equipment, earnings from those rentals will be indicated in Box 3. As with Box 2, the debt-to-equity ratio will apply when calculating UBIT.
This describes the money that was disbursed to your retirement plan, which may not match the figure in Box 1. If the figure is lower, it means the operating business has not yet issued cash earnings in full. If the figure is higher, the company paid amounts that were earned in prior years or returned capital contributions. However, taxes are calculated by the income described in Box 1, not the distributed amount described in Box 19.
It may seem like a burden, but UBIT (like any income tax) can be an indicator of success. As such, don’t let it discourage you from pursuing potentially lucrative investments in operating companies or debt-leveraged real estate. Profits retained after UBIT will remain in your IRA or 401(k) and no additional taxes will apply until you start taking distributions (for pre-tax accounts like Traditional IRAs). Please don’t hesitate to give us a call at 877-742-1270 or send us an e-mail at firstname.lastname@example.org with any other questions or concerns about IRA investing and UBIT.