Tax Talk: UBIT, Solo 401(ks) and More! – Guest Article with Adam Barr

When investing with Self-Directed IRAs (SDIRAs), understanding your responsibilities is one of the first things you need to make sure you know. In this guest article, CPA Adam Barr shares insight on helpful tax considerations and other helpful knowledge about tax-advantaged accounts. From unrelated business income tax (UBIT) to different special accounts, Adam shares what he’s learned during his time working with SDIRAs. 

Sarah: Thank you for joining me. Can you tell me a little bit about yourself?

Adam: I’m a CPA and I work as a tax manager here at MGA LLP, which is a local Houston accounting firm. We do tax and insurance services and outsource financial accounting for small businesses and the owners of those small businesses, both here in the Houston area and around the country. Even all around the world. My specialty… I’m a tax accountant, so I help a lot of my clients with tax compliance, tax planning and business planning, as well. Part of the reason we’re talking about self-directed IRAs today is that… a number of years ago I accidentally developed this as sort of a specialty. There was a vacuum in the market for CPAs who know a lot about UBTI and filing tax returns for Self-Directed IRAs. I had a little bit of experience in that field due to some clients we already had. It just sort of grew into a specialty, and now I’ve been working with Quest and helping their clients with these types of issues as they come up for the past few years. That’s a bit of who I am and what I do.

Sarah: So, you work with Self-Directed IRAs. When people are looking to begin investing with a Self-Directed IRA, what are some tax considerations, either positive or negative, that they should really be thinking about when getting started?

Adam: Yeah, sure. The positive tax advantage of having an IRA of any kind is that you have a deferral of tax. Most of the time when people are thinking about an IRA or a SDIRA, they’re talking about a traditional IRA, for which you get a tax deduction for putting money into. That allows people to defer some income into the IRA and to earn money on it tax free until they draw it out in retirement. You get a very long horizon of not having to pay tax on this money. What that helps you do is it helps you grow your money faster, because if it’s not being subject to tax and your earnings aren’t being subject to tax on an annual basis, you actually end up with a much higher net return after a long period of time. Then people need to watch out for unrelated business income tax (UBIT), which I think is something we’re going to talk about today, which can be something that people definitely want to consider before they invest in anything in a Self-Directed IRA. Depending on the type of investment, they could end up paying some tax on the income earned by that Self-Directed IRA each year. That changes what they should be expecting in terms of an after-tax investment return. I just think it’s very important that people should think about that and consider what their after tax return will be. That’s a general look at the positive and negative tax considerations related to a SDIRA.

Sarah: You mentioned UBIT. Can you talk a little bit about that? What is it for those that don’t know?

Adam: Absolutely. So, UBTI is unrelated business taxable income, and I’m going to distinguish that from UBIT, which is unrelated business income tax. So, UBIT, unrelated business income tax is the tax that your IRA has to pay on its unrelated business, taxable income or UBTI. So, the UBIT is just the tax on the UBTI. The UBTI is really the more important thing. 

Sarah: Then can you talk about that in more detail?

Adam: Sure. There are two ways in which an IRA can have unrelated business taxable income (UBTI). The first way is if the IRA is operating a trade or business. Now, a trade or business would include flipping houses and selling them for a profit, operating a retail store, or operating a restaurant. There’s any number of things. Anything that’s an operating trade or business, specifically. Not a rental property. Rental property is not considered a trade or business in this respect. In the case that you have an operating business, such as the ones that we just described, all of the income from that activity will be taxable to the IRA as unrelated business taxable income (UBTI). That would be all of the income. Now I’m going to distinguish that from the second scenario. That’s the first way in which an IRA can have UBTI. The second way an IRA can have UBTI is if it has what’s called unrelated debt financed income, which is referred to as UDFI. Unrelated debt financed income is any income that the IRA receives from a debt leveraged asset. A very common example, people will use their IRA to purchase a single family rental property, and they’ll take out a mortgage on the purchase of that property. Let’s just pretend that they take out a mortgage for 75% of the purchase price and their IRA puts up the other 25%. Their IRA will have unrelated debt financed income, because that is a debt leveraged asset. When the IRA earns the rental income from the property and pays the expenses, you’re going to have to take some portion of that as taxable income in the IRA, and the IRA is going to have to pay some tax on that. It depends on the percentage that the property is leveraged. If the rental property is 75% leveraged, as in our example, then roughly 75% of the net operating income of the property will be subject to unrelated business income tax in the IRA. Does that sort of make sense?

Sarah: Absolutely.

Adam: I use the rental property as an example of UDFI, but it can be anything. Anything that you purchased with that, an asset that you purchased with that the income from it will be taxable in the IRA.

Sarah: Perfect. I know I get a lot of people that call in and they’re actually, they’re concerned about it. Is UBIT something that they should be concerned of?

Adam: It’s not a monster hiding under your bed. It’s just something to be considered. I don’t think you should be afraid of it, but you do definitely want to consider it. As I alluded to earlier in our conversation, it affects what I’ll call your after tax return. Just like anything else in life, it doesn’t matter how much money you make. It matters how much you keep. If you’re going to earn rental income and you’re going to pay a little tax, you want to look at your return on your investment as, “what did I earn after paying that tax?” Is that an acceptable rate of return for you? So, I mean, it’s not something to be afraid of, but it’s something to be aware of.  You have to think about, well, if I invest in a debt leveraged asset in my IRA, I’m going to have to pay a little tax and I’m going to have to also get some help with preparing an annual tax filing to report that taxable income to the IRS and pay the tax. There’s a little bit of administrative effort and there’s some costs involved in preparing the return, but it doesn’t necessarily mean that it’s a bad idea. It still might be a really good investment. You just have to consider it.

Sarah: Let’s move on a bit to the potential accounts that could be exempt from that UBTI. We mentioned it and we discussed what it was, but what if someone wants to just completely avoid it, is that possible?

Adam: In some cases? Yeah. I think you’re talking in the direction of a solo 401(k).

Sarah: You got it. 

Adam: So, the answer is yes, that works depending on your circumstances. Solo 401(k)s have a bit of a loophole under the current tax law that says that they are not subject to the unrelated debt financed income (UDFI) rules. If you use a Solo 401(k) to purchase a debt leveraged asset, then the income from that asset will not be subject to UBTI, and you will not pay any tax and you will not have any form 990T tax return filing requirements. Now, if that same solo 401(k) owns an operating business, whether it’s debt leveraged or not, that is considered trade or business income and would be UBTI and would be subject to tax. So, it depends on the circumstances, but if we’re talking about the classic example of a rental property, such as a syndicated multifamily investment… if you hold that within a solo 401(k), then I would not anticipate there being any tax consequences.

Sarah: Yeah. People call in all the time and they want to open Solo 401(k)s as they are concerned about UBIT and we tell them it’s not something to be too worried about and to speak to a qualified CPA. Or… do you even qualify for solo 401(k)?

Adam: That’s the other big question. You have to be able to have a Solo 401k(). You can’t just make one. Right. You have to either have self-employment income or you have to own your own business or something like that. And you guys are probably pretty familiar with those roles. 

Sarah: Yes, and there are Certified IRA Specialists at Quest that can always answer questions clients may have. So, just to round it out here, do you have any final tips that you would give to people looking to start investing or that may already have an IRA or a 401k? Or anything you’d like to add that maybe I didn’t ask or anything that is important for our readers?

Adam: For some reason, I get a question a lot, so I bring this up every chance I get. I get the question, “well, a Roth IRA is a tax-free IRA. So UBTI doesn’t apply to a Roth IRA, correct?” And I always say that is not correct. UBTI applies to Roth IRAs in exactly the same way it applies to traditional IRAs. I think people get confused, because they think about Roth IRA withdrawals being tax free, and they assume that means UBTI does not apply, but that is not the case. It’s exactly the same rule. Lastly, the best time to start investing for retirement is last year. The second best time is right now. I’m a big proponent of putting away money for the future and utilizing these tax-deferred vehicles to do that. If you’re not sure what you want to invest in, you can still just go ahead and make that IRA contribution now and figure it out later, because you only get one. I always like to think of it this way: You only get one chance to make an IRA contribution. For example, for tax year 2020. If you just say, “I’ll figure it out next year”, then you’ve missed that opportunity forever. Right? Sure, you can make a contribution this year, but you could’ve made a contribution for 2020.

Sarah: That’s a great point to end on. Thank you so much for taking the time to speak with me and share your knowledge with me! This has been very helpful, and I know our readers will benefit greatly from this information!Whether you’re trying to understand UBIT or just want more information about the types of tax-advantaged accounts, feel free to reach out to an IRA Specialists at 855-FUN-IRAs (386.4727). If you’d like to contact Adam Barr for more help, he can be reached at abarr@mgallp.com.

How is an IRA Taxed?

No matter what type of IRA you choose, you will eventually pay taxes on it. The question becomes, do you want to pay taxes up front or on the back-end at retirement? If you would rather pay taxes now (for example: you think your tax rate will be lower now than in the future), then a Roth IRA is the way to go. There are income restrictions for qualifying for a Roth, however you can get around this by rolling over funds from a Traditional into a Roth account. If you would rather pay taxes on your distributions upon retirement and enjoy a tax write-off now, then Traditional IRAs are right up your alley. This, of course, is the most simplified explanation. And we all know taxes are a bit more complicated when further investigated.

How Are Roth IRAs Taxed?

With Roth IRAs you don’t get a tax write-off when you make contributions, and you will owe taxes on your contributions based on your income and tax bracket at the time of the contribution. If you qualify for the Saver’s Credit, the amount you owe in taxes may be reduced.

One of the greatest benefits of a Roth IRA is that you do get to pull funds out tax-free under the right conditions. As long as a Roth IRA has been open for 5 years or you are over 59 ½, whichever comes later, you can take distributions on your earnings tax-free. Qualified home purchases and disability requirements also qualify for tax-free status.

If you haven’t had the account for at least 5 years or haven’t reached age 59 ½ yet, you may have to pay a penalty in addition to tax on certain distributions. Distributions on contributions are always penalty free, but not always tax free. Distributions on earnings may be subject to both tax and penalty depending on the circumstances. To learn more about Roth IRA withdrawals, click here.

How Are Traditional IRAs Taxed?

With Traditional IRAs, you can write off your yearly contributions if you meet certain income requirements, but you will owe taxes upon distribution at retirement based on your tax bracket at the time. Traditional IRAs require savers to start taking minimum distributions at age 72 that are based on how much is in the account and your age.

You may also be taxed and fined on Traditional IRA distributions if you withdraw funds before age 59 ½. Just like with Roth IRAs, there are extreme exceptions to this rule. However, one should consider all of the costs, including loss of compounded interest and taxes, before withdrawing early.

To pay taxes required on any qualifying distributions, you will just need to include your contributions and distributions on your yearly tax filing paperwork and use this to figure the amount owed. A tax professional can help you through the process if you are unsure.

One last note on retirement account taxes: You can make a distribution that moves you into a higher tax bracket. If it’s an RMD for a Traditional IRA, you may not have a choice. However, you may want to perform some calculations first to ensure you’re not paying more in taxes than you need to. Always consult your financial advisor before taking any out-of-the-norm distributions.