For many years, the employer-sponsored retirement plan, whether it be a 401(k) plan or defined benefit plan, has been the backbone of the U.S. taxpayer’s retirement savings. With the ease of entry into these plans, employer matching contributions, and relatively strong rates of return over the past few decades, most folks with these accounts have had little to complain about.
These days, however, individual retirement accounts (IRAs) have become more and more popular among all taxpayers, particularly those who are either at or are nearing retirement age. In addition to those retiring, there have also been many younger folks that have switched jobs over the past several years, especially during the Great Resignation. In doing so, many of these folks opted to roll over their employer-sponsored plans into one or more IRAs. In fact, according to a study conducted by the financial services research firm Cerulli Associates, since 2020 nearly $2 trillion has been rolled over by U.S. taxpayers from qualified retirement plan accounts to IRAs. Moreover, the Federal Reserve reported that as of December 31, 2022, assets in IRA accounts alone totaled almost $11.5 trillion – nearly as high as the dollars invested in private-sector defined benefit and defined contribution plans combined.
What are the advantages of an IRA over an employer-sponsored plan? For those who have changed jobs or retired, migrating those funds to an IRA can give you more visibility and control over those funds. In addition, the IRA allows for its owner to have more say as to the types of assets that the IRA can hold, whereas the investment options for an employer-sponsored plan are often limited to a much smaller menu to select from.
With interest rates expected to remain at 40-year highs, many folks are of the opinion that investments in the stock market will not be as strong as the returns they have been accustomed to in recent memory. This sentiment may entice these folks to direct their available cash into nontraditional assets, such as real estate and equity investments in privately held companies. And, if invested through their IRA, such investments have the potential to grow either tax-deferred (traditional IRAs) or tax-free (Roth IRAs).
If you have determined that a nontraditional asset is a good investment opportunity and stands up on its own merits, you may be tempted to use your IRA assets to acquire the investment. If you do, there are several factors that should be considered carefully before investing with your IRA.
Nontraditional Assets Are Generally Riskier Than Stocks and Bonds
Nontraditional assets are generally not registered with the Securities and Exchange Commission (SEC). While many nontraditional assets can, and often do, deliver returns that beat the market, some unfortunately are not as successful and can run losses. Individuals who will be relying on their IRA nest egg in retirement might put their retirement security at risk if the nontraditional investment doesn’t pan out. Also, keep in mind that any losses incurred within an IRA cannot be deducted by the IRA owner on their individual income tax returns.
Those who wish to make any investment in a nontraditional asset, or any investment for that matter, are strongly advised to do their homework and obtain as much information as possible about the investment they are looking to make, prior to committing their dollars to it.
Fair Market Value Reporting Requirements
IRA custodians must report to the IRS on an annual basis the fair market value of the IRA as of the end of each tax year. This reporting is easy when the IRA holds assets that are publicly traded, such as stocks and exchange-traded funds, since they have a readily determinable fair market value. However, when the self-directed IRA holds nontraditional assets, such as a partnership interest in a partnership, it may be more difficult to assign a value to those assets. The IRA owner is responsible for providing the custodian of the IRA with these values each year. That becomes a task the IRA owner should not forget to do.
An IRA owner can obtain the nontraditional asset’s fair market value directly from the issuer, or they can engage a qualified valuation expert to determine the value of the asset. The latter is often expensive, especially when considering it must be done every year to meet IRS requirements. This would also be a consideration when subject to Required Minimum Distributions (RMDs) as they are calculated based on the IRA value on December 31st of the year before.
In a recently issued Tax Court opinion, Estate of James E. Caan, Deceased, Jacaan Administrative Trust, Scott Caan, Trustee, Special Administrator v. Commissioner, 161 T.C. No. 6, the taxpayer’s IRA had an investment in a partnership interest, which was required to be valued on an annual basis. The IRA custodian ended up resigning on account of the IRA owner not providing the fair market value information after multiple requests went unanswered. In doing so, the partnership interest was distributed in-kind to the IRA owner. Although the matter took several years and litigation to resolve, the ultimate result was the recognition of a taxable event based on the fair market value of the partnership interest in the year of the in-kind distribution.
Unrelated Business Income Tax (UBIT)
IRA owners who invest in active businesses or debt-financed properties need to be aware of the unrelated business income tax (UBIT). The tax-favorable status of IRAs limits the type of income that can be accumulated within the account on a tax-free basis. Income that is exempt from UBIT includes interest, dividends, annuities, royalties, most rental income from real property, and gains from the sale or exchange of property other than inventory or property held for sale in the normal course of business.
Any income that does not fall into one of the above categories is considered unrelated business taxable income (UBTI). IRAs with UBTI in excess of $1,000 must file Form 990-T on an annual basis by May 15th and pay tax on its UBTI. IRAs are subject to tax at the same rates that apply to estates and trusts, with income over $14,450 being taxed at 37%. Any tax due must be paid by the IRA. If the IRA owner makes the tax payment on behalf of the IRA, such payment would be treated as a contribution to the IRA, which may or may not be allowed based on IRA contribution limits and the IRA owner’s individual tax situation.
Special rules apply for income attributed to property that has been financed with debt proceeds. In these cases, the IRA must calculate the portion of the income that is attributed to the financed portion of the property in order to figure their UBTI. Consider the following example – an IRA owns a 10% ownership stake in a partnership that holds rental real estate. The partnership’s rental real estate asset is acquired for $20,000,000 – 50% with cash, and 50% with debt proceeds. The rental activity has taxable income of $200,000 for the year, 10% of which is allocated to the IRA investor. The IRA has UBTI of $10,000 ($200,000, multiplied by the IRAs 10% ownership interest, multiplied by the 50% of the property financed by debt). If not for the property being financed with debt, the rental real estate income would otherwise not be considered UBTI.
But that’s not all. The Tax Cuts and Jobs Act of December 2017 implemented a provision that requires IRAs to measure the income and losses from each unrelated business activity separately. The activities with losses cannot be used to offset income from a separate activity. Any losses from unrelated activities are carried forward indefinitely and can only be used against the unrelated business taxable income from that activity.
Prohibited Transactions
While an IRA is able to hold nontraditional assets, the IRA is prohibited from engaging in certain types of transactions. Generally, a prohibited transaction is any transaction between, or use of the IRA by, the IRA owner, beneficiary or any disqualified persons. The key is that the rules restrict who the IRA may transact with. The term ‘disqualified person,’ as defined within the Internal Revenue Code, includes the IRA owner, immediate family members and certain related trusts and business entities or anyone that provides services to the IRA (including the IRA owner, trustee or custodian of the IRA).
Prohibited transaction issues tend to be more common with self-directed IRAs. Owners of self-directed IRAs would be wise to consult with their trusted tax advisors prior to engaging in any transactions that have even the slightest possibility of being viewed as a prohibited transaction. If the IRA engages in even one prohibited transaction, the IRA can lose its tax-exempt status, and the entire balance of the IRA becomes taxable to the IRA owner as of the first day of the tax year. This can be a disastrous result for IRA owners who have accumulated wealth within their IRAs that otherwise would have been tax-free or tax deferred.
Closing thoughts
It is important to remember that the IRA is its own entity, separate and distinct from its owner. While investments in nontraditional assets can be a beneficial addition to an investor’s portfolio under the right circumstances, those who are not prepared for the burdens and potential pitfalls associated with these investments may soon be faced with an outcome they are neither expecting nor are prepared for.
If you need further guidance or have any questions on this topic, we are here to help. Please do not hesitate to reach out to discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.