The upside of traditional IRAs is that income taxes aren’t due until money is withdrawn…and with Roth IRAs, investment profits are not taxed at all.
But: IRA owners—even those who own Roth IRAs—who break some obscure IRS rules can end up owing taxes on investment profits at rates as high as 37%. Even worse: Their IRAs can be “deemed distributed,” meaning that the IRS acts as if all assets have been withdrawn from the IRA, triggering taxes and penalties.
These dangers don’t apply if your IRA is entirely invested in stocks, bonds and mutual funds. IRAs that are at risk contain other assets such as real estate, limited partnerships, hedge funds, private equity funds and/or non-fungible tokens (NFTs). Investments such as these have become more common in IRAs because investors have been worried about the state of the stock and bond markets.
Here are three IRA tax traps to avoid…
- Mishandling real estate. You can hold real estate in an IRA—but you cannot live in the property…allow a family member to live there, with or without rent…use it as a vacation home or for other personal purposes…or personally perform maintenance or repairs on it. If you do any of these things, the IRS deems the entire IRA distributed, triggering taxes and, if you’re not yet 59½, also a 10% early-withdrawal penalty.
What to do: If you hold real estate in an IRA, hire a property-management company and/or contractors to do any necessary work. Never use the property for a personal purpose—one man had his IRA deemed distributed by the IRS because he parked his non-IRA–held tractors on IRA-held land. Related: If you hold real estate in an IRA, have more liquid IRA investments as well—otherwise, it will be difficult to make required minimum distributions (RMDs) without selling the property.
- Gaining certain income from limited partnerships, hedge funds and private-equity funds. “Alternative investments” are allowed in IRAs—but if they generate income from their business activities and pass a portion of that income along to you, the IRS will consider it “unrelated business taxable income” (UBTI). UBTI is taxable even when held in an IRA, after a $1,000 annual exemption. In fact, UBTI is taxable at trust tax rates—37% for amounts above $14,450 in 2023.
What to do: Discuss the UBTI-generating potential of alternative investments with your tax advisors. If your IRA earns more than $1,000 of UBTI in a year, confirm that your IRA custodian has filed IRS Form 990-T, Exempt Organization Business Income Tax Return.
- Holding NFTs that convey rights to collectibles. Collectibles, including art and antiques, cannot be held in IRAs. In March 2023, the IRS ruled that an NFT is considered a collectible and not allowed in an IRA if the NFT provides its owner with the rights to a collectible. Example: An NFT that certifies ownership of a piece of art is not allowed. Breaking this rule results in taxes being due on the amount originally paid for the NFT, even if the current value of the NFT is far lower.
What to do: Be wary of placing anything that could be considered a collectible in your IRA. Potential exception: Certain coins and precious metal bullion don’t fall under the IRS’s definition of collectibles—see IRS Publication 590-A, Contributions to IRAs.