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Unsuspecting Investors May Owe Taxes on Their Individual Retirement Accounts (IRAs)

As described in a recent article in The Wall Street Journal (“Are Taxes Lurking in Your Tax-Free Retirement Account”), many Americans are now receiving notices informing them that they owe additional taxes on their traditional individual retirement accounts (IRAs).

Although investors have been led to believe that their retirement accounts were normally tax-free, it is entirely possible to owe annual tax on a tax-deferred traditional IRA or tax-free Roth IRA, even allowed investments.

“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.”

The reason why there are taxes on an apparently tax-free account is that these accounts must pay income tax on the “Unrelated Business Taxable Income,” or UBTI, which can often arise when an IRA invests in operating businesses that pass profits and losses directly to the owners, such as partnerships, master limited partnerships and limited-liability companies.

As more IRA owners look to invest in alternative assets for accounts large and small, here’s what the WSJ advises investors to know – and document – before they invest their funds:

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 as many publicly traded partnerships do – especially when units are sold.

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. There may also be state income tax implications, such as additional taxes owed, and required filings for each state in which the investment entity conducts its operations.

If you are an individual or institutional investor who has any concerns about your retirement account investments, please contact us for a no-cost and no-obligation evaluation of your specific facts and circumstances. You may have a viable claim for recovery of your investment losses by filing an individual securities arbitration claim with the Financial Industry Regulatory Authority (FINRA).

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