Understanding Unrelated Business Income Tax (UBIT) in Your IRA

Do you own a traditional IRA, Roth IRA, SEP-IRA or SIMPLE IRA? These retirement accounts typically offer tax-free growth on investments in common assets such as stocks, bonds, mutual funds, ETFs, CDs and Treasury Bills.

However, if your IRA engages in alternative investments, you may be subject to a special tax known as Unrelated Business Income Tax (UBIT)—even if it’s a Roth IRA.

When Does UBIT Apply?

While most IRA investments remain tax-advantaged, UBIT can be triggered in two key scenarios:

Investing in Active Businesses

If your IRA invests in an S-corporation, limited partnership, regular partnership or an LLC engaged in an active business, it may owe UBIT. C-corporations are exempt from this rule, as they pay their own taxes.

A common UBIT-triggering investment is a master limited partnership (MLP), where the IRA’s share of business income could be taxed under UBIT.

Using Debt Financing in a Self-Directed IRA

If your self-directed IRA purchases real estate or other assets using borrowed money, it may owe UBIT on unrelated debt-financed income (UDFI).

For example, let’s say your IRA buys a $500,000 rental property but finances $250,000 with debt. 50% of the rental income is subject to UBIT.

How UBIT Works

Understanding the tax implications of UBIT is crucial for making informed investment decisions within your IRA:

• Tax Rates: UBIT is taxed at trust tax rates, meaning it reaches the highest 37% tax bracket at just $14,450 of taxable income.
• Annual Exemption: Each IRA receives a $1,000 exemption from UBIT.
• Filing Requirements: If an IRA generates more than $1,000 in unrelated business taxable income, it must file Form 990-T electronically. In addition, the IRA custodian (not the account holder) must pay the tax.
• Double Taxation for Traditional IRAs: A traditional IRA paying UBIT gets hit twice—first at trust tax rates and again when funds are withdrawn as ordinary income.

Avoid UBIT-Generating Investments

While self-directed IRAs provide flexibility to invest in alternative assets, it’s important to understand the tax consequences. If UBIT applies, it could significantly reduce your IRA’s growth potential.

For most investors, the best approach is to avoid investments that generate UBIT to maximize tax-deferred or tax-free growth within their retirement accounts.

For help with all your IRA planning and structuring, contact Illumination Wealth today.