Problematic Investments in Tax-Favored Retirement Accounts

Tax-favored retirement accounts (traditional IRA’s, Roth IRA’s, 401(k)’s, etc.) can be invested in just about anything you like, if it’s offered by the institution or trustee holding your account. But there are some types of investments that should be avoided in these accounts because the Tax Code throws some road blocks in front of them. Here’s a brief catalog of these problematic investments. If you want to invest in one of these, purchase it outside your retirement account, in an ordinary taxable investment account.

Collectibles. If you use any of the funds in your IRA to invest in collectibles, then that amount is treated as if distributed to you and subjected to income tax. The same treatment applies to your account under a 401(k) plan or other employer plan under which you have the right to direct the account’s investments. “Collectibles” are artwork, antiques, metals, coins, stamps, and the like.

Unrelated Business Taxable Income. If your tax-favored retirement account invests directly in an unincorporated business, the net income earned from that investment (called UBTI for short) is subject to income tax. For example, if your IRA invests in tangible personal property which it leases to third parties, that creates UBTI. (There was an article in the New York Times about a year ago describing a music teacher who used his IRA to buy musical instruments which were then leased to his students. He bragged about the great return on his investment. But the article failed to mention the tax his IRA will have to pay.)

Limited Partnerships. If your tax-favored retirement account invests in a limited partnership, even a publicly traded master limited partnership, and the partnership is engaged in a business, that creates UBTI.

Debt-Financed Income. If your tax-favored retirement account borrows money, directly or indirectly, the portion of its income attributable to the borrowed funds is subject to income tax. For example, if your IRA trades stocks on margin, that creates debt-financed income which is subject to income tax. Similarly, if it invests in a hedge fund organized as a limited liability company (LLC), and the LLC is engaged in borrowing of any kind, that too results in income tax to the account.

Life Insurance.
In IRAs. An IRA is not permitted to invest any of its assets in life insurance, and will lose its tax-favored status if it does—an awful result.
In other retirement plans. Employer plans (like 401(k) plans) are permitted to invest in life insurance within limits. If your employer’s retirement plan provides you with life insurance protection, the value of that insurance protection is taxed to you each year.

Participant Loans. Employer plans, but not IRAs, are permitted to make loans to plan participants. However, such loans must meet guidelines imposed by the Tax Code. If a participant loan fails to meet those guidelines, the outstanding amount of the loan is treated as if distributed to the participant, and subjected to tax at that time. This problem is most likely to occur if the plan participant fails to repay the loan in accordance with its terms.

Pledging IRA Assets. If you pledge your IRA as security for a loan, the IRA (or the portion of it subject to the pledge) will be treated as if distributed to you and subjected to income tax.

Prohibited Transactions. “Prohibited transactions” are transactions that involve your account and someone related to the account, such as you or a member of your family. A prohibited transaction between your IRA and you results in the entire IRA totally losing its tax-favored status. A prohibited transaction between your IRA and another party related to the IRA (e.g., the financial institution at which it is housed, or a relative of yours) results instead in a substantial monetary penalty. Prohibited transactions come in two broad flavors: objective and subjective:
Objective. Any transaction between your account and you or a member of your family is prohibited. These are relatively easy to spot. For example, if your IRA purchases an investment from you, even for fair market value, that is a prohibited transaction.
Subjective. A more subtle prohibited transaction is one which is done for the benefit of you or a member of your family. For example, remember the music teacher? If his IRA leased musical instruments to his students to help him generate teaching fees, that’s a prohibited transaction.

Real Estate. Investing a retirement account in real estate is not a problem per se. But it creates so many potential avenues for problems, it ought to be avoided. I will cover these in a later post.

Now that you know about the problem areas you can go invest your retirement account in something safe. Like the stock market.