As people retire, they face numerous tax rules that can lead to unexpected outcomes. Social Security retirement benefits are partially taxable while required minimum distributions (RMDs) start as soon as you turn 70 1/2.
Tax professionals and financial advisers frequently underestimate the tax inefficiencies inherent to passing on retirement assets to future generations.
Self-Directed IRAs
If your clients wish to diversify beyond traditional stocks, bonds and mutual funds in their retirement accounts and are in search of higher investment returns than what the stock market can provide, self-directed IRAs (SDIRAs) might be of great interest. These retirement accounts offer greater flexibility than traditional ones by permitting investors to select alternative assets from a wide array.
SDIRAs must be managed by an approved custodian or trustee in order to comply with IRS rules and regulations, while clients should also expect to devote additional time in conducting due diligence on their investments.
Rollover of IRA or Roth IRA distributions into an SDIRA may seem attractive, but clients should remember that such transfers are only allowed once annually and any withdrawals between are taxable. Also, any distributions must be taken by April 1 of the year following age 70 1/2 otherwise they risk incurring a 50% excise tax penalty.
Prohibited Transaction Rules
The IRS has strict rules in place regarding prohibited transactions that could disqualify your IRA. It’s prohibited to use assets from an IRA to pay personal credit card bills or purchase or sell investments with disqualified parties in one transaction.
An IRA may run into trouble when investing in properties that generate unrelated business taxable income (UBTI). For instance, investing in partnerships or LLCs operating real estate that generate rental income could subject your IRA to unrelated business taxable income taxes.
Finally, it’s essential to remember that required minimum distributions (RMDs) are subject to tax when they occur. RMDs must begin being taken beginning the year you turn 70 1/2 unless applicable and subject to certain exemptions such as first-time home buyers or meeting certain other exceptions. Failing to take your RMDs or having an excessive amount may incur an additional penalty tax of up to 5.5 percent.
Unrelated Business Taxable Income
IRAs were originally intended to be tax-deferred investments, but the tax code now allows certain forms of income that will trigger immediate income taxes. Unrelated Business Taxable Income, or UBTI, is one such source that often arises when investing in operating businesses, owning equity in partnerships conducting trade or business, or using borrowed funds to finance investments.
An example of self-directed IRA ownership would be investing in an operating restaurant which generates revenue through food and beverage sales, receiving K-1 forms from each year that detail its income and expenses, with any net taxable income considered UBTI and subject to current income tax, even though this falls within one of five investment income exemptions.
As it’s easy to see, these traps can result in unexpected tax bills for IRA owners when they least expect it, financial professionals should hold a candid conversation with clients approaching retirement regarding the risks associated with retirement accounts.
Unrelated Debt-Financed Income
Numerous retirees possess substantial funds in tax-deferred savings and investments such as traditional or Roth IRA accounts, after-tax savings from prior employment or inheritance funds that they believe won’t create a current income tax bill; however, this may not always be the case.
IRAs that engage in activities unrelated to their tax-exempt purpose, such as renting real estate or selling tangible personal property such as inventory, will be subject to Unrelated Business Income Tax (UBTI). UBTI tax must be reported using IRS Form 990-T.
One way to reduce UBTI risk is through borrowing to finance investments. Leveraging an investment with debt in an IRA may increase returns but must be carefully considered as when purchasing property with debt, any profits attributable to ownership percentage tied to non-recourse loan must be subject to UBTI taxation.
