While everyone knows that earnings grow in retirement plans on a tax-sheltered basis, don’t assume this means your IRA doesn’t owe taxes for other reasons. In fact, there are three main reasons your retirement plan may indeed incur taxation. Failing to understand this and neglecting to pay can get you in some serious hot water with the IRS.
Property Taxes on Real Estate Investments
This one’s a no brainer, but we had to cover it anyway since real estate investments are the most popular assets in IRAs. So, while you may indeed make quick tax-sheltered income on property purchased and sold within retirement plans (i.e., rehabs, commercial property, etc.)—the account is still liable for the property tax bill. Especially if your IRA has not sold the property by the time those taxes are due. This is important to know if your IRA is invested in rental property, as well. Every year, property taxes are assessed—and every year your IRA owns a piece of property it will owe these taxes relevant to that real estate asset. The good news is your IRA pays this bill, not you personally.
Unrelated Business Income Tax (UBIT)
This is kind of complicated, so be sure to consult with your tax advisor or financial consultant here. But, if your retirement plan owns a business, unrelated business income tax may be owed relevant to the net income generated by that business. This occurs if the company pays profits to the IRA before it pays taxes. However, if the business pays taxes before distributing payment to the retirement plan, UBIT is not owed.
UBIT is also owed if the asset purchased by the retirement plan was leveraged through the use of a non-recourse loan, in which case, the net income generated by the debt-financed portion of the asset is taxed.
Unrelated Debt-Financed Income (UDFI)
If your IRA borrowed money to leverage the purchase of an investment, unrelated debt-financed income will probably be assigned to the percentage of the investment that was leveraged. For example, say your IRA funds 70% of the purchase of an asset and it took out a non-recourse loan to fund 30%. In this case, 30% of the net income generated by the investment may be subject to UDFI. Again, consult with a professional to fine-tune the details correctly as this can sometimes be challenging to determine on your own.
Even though contemplating paying taxes is never fun, don’t let the above deter you from investing using a self-directed retirement plan. Don’t let this knowledge keep you from owning a business in your retirement plan or even from taking out a non-recourse loan to invest. Sometimes, these things are simply the cost of doing business when investing. If you find the right asset and it proves to be fruitful—the income you can potentially make to secure a successful retirement far outweighs the tax implications outlined above.