Is your tax-free IRA really tax-free?

According to a recent article in The Wall Street Journal, 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.

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.

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.
  • 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.
  • 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.

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