Retirement accounts like IRAs (Individual Retirement Accounts) and 401(k)s offer significant tax advantages, allowing individuals to grow their investments tax-deferred or tax free in the case of a Roth. However, these benefits come with certain limitations, especially when it comes to generating income from business activities. One of the critical concepts that investors must understand in this context is Unrelated Business Taxable Income (UBTI).

Understanding UBTI and how it affects retirement accounts, the types of investments that can trigger the tax, and strategies to manage or avoid UBTI-related taxes will be discussed in the following.

Introduction to UBTI

Unrelated Business Taxable Income (UBTI) refers to income earned by tax-exempt entities, including retirement accounts, from activities unrelated to their primary purpose. For retirement accounts, the primary purpose is to grow savings for retirement. However, if the account engages in certain types of income-generating activities, it may incur UBTI, which is subject to taxation.

The UBTI rules were created to prevent tax-exempt entities, including retirement accounts, from unfairly competing with taxable businesses by engaging in regular business activities.

How UBTI Affects Retirement Accounts

Retirement accounts are designed to provide tax-deferred or tax-free growth. Traditional IRAs and 401(k)s allow contributions to grow tax-deferred until withdrawals are made, while Roth IRAs offer tax-free growth on after-tax contributions. However, when a retirement account generates UBTI, the income becomes taxable in the year it is earned, even if the account is otherwise tax-exempt.

Key Implications:

• Taxation on Income: UBTI generated within a retirement account is subject to the trust tax rates, which can be as high as 37%. This tax must be paid from the retirement account itself, reducing the overall balance.
• Filing Requirements: The custodian of the retirement account must file IRS Form 990-T to report and pay the tax on UBTI.

Understanding how UBTI can affect retirement savings is crucial for investors to avoid unexpected tax liabilities.

Common Investments That Generate UBTI in Retirement Accounts

Not all investments trigger UBTI. However, certain types of investments can lead to UBTI, which can impact the tax benefits of a retirement account.

Investments that commonly generate UBTI include:

• Private Equity and Venture Capital: These investments often involve buying into partnerships or LLCs that operate active businesses. The income generated from these businesses can be classified as UBTI.
• Real Estate Investments: Real estate investments, particularly those involving debt-financed property, can generate UBTI. The portion of income attributable to the debt is considered UBTI under the “Debt-Financed Income” rules.
• Master Limited Partnerships (MLPs): MLPs are publicly traded partnerships, and the income they distribute is typically considered UBTI when held in a retirement account.
• Limited Partnerships (LPs) and Limited Liability Companies (LLCs): If these entities are engaged in operating businesses, their income can be considered UBTI for retirement accounts.

Example: If an IRA invests in a limited partnership that operates a restaurant chain, the income generated from the restaurant operations would likely be considered UBTI. Similarly, if a retirement account invests in real estate using borrowed funds, the rental income attributable to the financed portion is UBTI.

Calculating UBTI and Filing Requirements

UBTI is not necessarily triggered by the total income from an investment but rather by the net income after accounting for related deductions. The key threshold for UBTI is $1,000. If the net UBTI exceeds this amount, the retirement account must file IRS Form 990-T and pay the appropriate tax.

Steps to Calculate UBTI:

1. Identify UBTI-Generating Investments: Review the retirement account’s holdings to determine which investments generate UBTI.
2. Determine Gross UBTI: Calculate the gross income from these investments.
3. Deduct Related Expenses: Subtract any directly related expenses, such as operating costs or interest on debt-financed property, to determine net UBTI.
4. Apply the $1,000 Deduction: The first $1,000 of UBTI is exempt from tax. Any UBTI above this threshold is taxable.

Filing Form 990-T

If a retirement account generates more than $1,000 in UBTI, the custodian is responsible for filing Form 990-T and paying the tax from the account. The deadline for filing is typically the same as the regular tax filing deadline, though extensions may be available.

Strategies to Manage or Avoid UBTI

Investors can employ several strategies to manage or avoid UBTI in their retirement accounts. These strategies help minimize the tax burden and preserve the tax-advantaged status of the account.

• Avoid UBTI-Generating Investments: One straightforward approach is to steer clear of investments that are likely to produce UBTI, such as MLPs or debt-financed real estate.
• Use Retirement Accounts Strategically: Hold UBTI-generating investments in taxable accounts rather than retirement accounts, preserving the tax advantages of the latter.
• Consider “Blocker” Entities: In some cases, forming a blocker corporation or investing through an entity that blocks UBTI can prevent the income from being classified as UBTI. This strategy is more complex and typically requires professional guidance.
• Monitor Investment Income: Regularly review and monitor the income generated from retirement account investments to stay under the threshold where possible.

Example of Strategic Planning: An investor might hold MLPs in a taxable brokerage account to benefit from pass-through income while avoiding UBTI in their retirement account. Alternatively, an investor could explore investing in MLP exchange-traded funds (ETFs) structured to minimize UBTI.

Case Studies

Case Study 1: Real Estate in an IRA

An investor holds real estate within his Self-Directed IRA. The property is financed through a non-recourse loan, which means a portion of the rental income is classified as UBTI. The investor works with his custodian to calculate the UBTI and files Form 990-T, paying the tax from the IRA. Over time, the investor decides to pay off the loan to eliminate future UBTI.

Case Study 2: MLPs in a Roth IRA

An investor holds several MLPs in a Roth IRA, attracted by their high dividend yields. However, the investor discovers that the MLP income is subject to UBTI. After consulting with a tax advisor, the investor sells the MLPs and replaces them with a similar ETF that does not generate UBTI. This move preserves the tax-free growth of the Roth IRA.

Conclusion

UBTI can complicate the otherwise straightforward tax benefits of retirement accounts. Understanding how UBTI works, the types of investments that can trigger it, and how to manage or avoid it is essential for investors looking to maximize their retirement savings.

Regularly review your retirement account’s investments for potential UBTI-generating assets. Be sure to consult with tax professionals or financial advisors before making complex investments within your retirement account. You may want to consider alternative investment vehicles or strategies that align with your retirement goals without triggering UBTI. By staying informed and proactive, investors can navigate the complexities of UBTI, ensuring their retirement accounts continue to grow in a tax-advantaged environment.