Tax On My IRA? OMG!

Tax on my IRA?  Say what?! The Wall Street Journal recently told the story of Fanny Handel, a retiree who was floored when she received a notice from the IRS that she owed $92,000 in taxes on her traditional IRA. As many do, she assumed what she earned in her IRA was tax free. But that is not always the case. While gains from the sale of stocks, dividends, and bond interest all accrue tax free (only taxed when the money is withdrawn from the IRA), returns from other types of investments are taxed to the IRA when they are earned.

What types of investments can cause so much trouble in an IRA? Investments in ‘alternative’ assets such as hedge funds, private-equity funds, limited partnerships, operating businesses and real estate can carry a nasty tax burden. Of those, perhaps the biggest risk is limited partnerships. That’s because a very common type of investment these days is a Master Limited Partnership or MLP. MLP’s are very common investment vehicles in the oil and gas arena. And, it’s what got Ms. Handel into trouble. She apparently owned thousands of “units” of Kinder Morgan, Inc., a popular MLP.

So what the heck is the deal, you ask? Haven’t we all been told for decades that investing in an IRA is one of the best ways to save for retirement because you DON’T pay taxes until you have to begin withdrawing the money at age 70 1/2? We have been and that’s all true. With one odd little exception – Unrelated Business Taxable Income.

What on earth is that? And why does it affect you? Well apparently our Congress decades ago decided that this concept, that originally arose to apply to non-profit entities, should apply to IRAs. Unrelated Business Taxable Income or UBTI is meant to level the playing field between for-profit and non-profit businesses. So if a non-profit makes money from donations or from fees in exchange for its core services, no problem. But if a non-profit, like the YMCA, owns and operates a separate noodle business, it must pay tax on that income because it is “unrelated” to the core mission and operation of the YMCA. If the non-profit doesn’t have to pay tax like a for-profit business it would have an unfair advantage with its noodle business.

What all this means for IRA owners is that money from certain alternative investments – MLPs, hedge funds, real estate, operating businesses, etc. – gets taxed as UBTI. To make matters worse, UBTI is taxed at very compressed rates, meaning the top tax rate applies when you reach just $12,000 of UBTI. That can make for a nasty tax bill.

In short, most people should probably stick with stocks, bonds, ETFs, and mutual funds in their IRAs. For anything other than those, you would be wise to consult your tax advisor before you buy.

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