Unfortunately, most financial advisors only have a surface level understanding of the tax code, and with the popularity of private equity few of these advisors understand the tax consequences of private equity in retirement accounts. A frequently overlooked risk associated with private equity and certain alternative investments involves something called Unrelated Business Taxable Income (UBTI).
Most investors reasonably assume investments held within an IRA, Roth IRA, or 401(k) are sheltered from current income taxation. After all, isn’t tax deferral—or tax-free growth in the case of a Roth IRA—one of the principal advantages of retirement accounts?
Unfortunately, the Internal Revenue Code contains an exception capable of producing an unpleasant surprise.
What Is Unrelated Business Taxable Income (UBTI)?
Unrelated Business Taxable Income, commonly referred to as UBTI, is generally income earned by a tax-exempt entity from business activities unrelated to its tax-exempt purpose, after applicable deductions and adjustments. Although we typically associate tax-exempt organizations with charities and nonprofit institutions, retirement accounts such as IRAs are also treated as tax-exempt entities under federal tax law.
The primary purpose of an IRA is to accumulate assets for retirement, not to operate a commercial enterprise. Consequently, when an IRA owns an interest in a partnership conducting an active business, the income allocated to the retirement account may become subject to taxation even though the account itself ordinarily enjoys tax-favored treatment.
For example, imagine your IRA invests $200,000 in a private equity partnership. The partnership subsequently purchases several privately held businesses, including a manufacturing company generating substantial operating profits.
Because the partnership generally passes its taxable income through to its investors, a portion of the manufacturing company’s business income may ultimately be allocated to your IRA. Depending upon the underlying business activities and investment structure, this income could constitute UBTI.
Importantly, your IRA could owe income taxes even if the private equity partnership never distributes a single dollar of cash to your retirement account.
And the complications do not necessarily end there.
Many private equity investments utilize leverage, meaning they borrow money to acquire businesses or other assets. This borrowing can generate another category of potentially taxable income known as Unrelated Debt-Financed Income (UDFI). Under certain circumstances, investment income ordinarily excluded from UBTI becomes taxable when attributable to debt-financed property.
Not every private equity investment generates UBTI, and certain qualified retirement plans, including qualifying 401(k) trusts, benefit from special exceptions for some debt-financed real estate investments. Nevertheless, these rules introduce another layer of complexity; investors should understand the tax consequences of private equity in retirement accounts before committing their retirement savings to alternative investments.
How Much UBTI Can an IRA Have Before Owing Taxes?
When an IRA generates $1,000 or more in gross unrelated business income during a tax year, it generally must file IRS Form 990-T, the Exempt Organization Business Income Tax Return.
The $1,000 filing threshold should not be confused with the amount of taxable income. The actual tax calculation considers applicable deductions and adjustments, including a specific deduction of up to $1,000. The UBTI tax rate is 10% to 37%, with the highest bracket coming into play once UBTI exceeds $13,950 (2026 threshold).
Typically, a large accounting firm, like Deloitte or KPMG, will prepare the 990-T tax return for the IRA at the direction of the retirement account custodian (i.e., Schwab). Once the custodian prepares the return, it will pay the tax automatically. You, as the owner of the retirement account, have zero input into this process. The tax due is paid from the retirement account itself, diminishing the assets otherwise available for future tax-deferred or tax-free growth.
Furthermore, partnership investments commonly generate Schedule K-1 tax forms, requiring additional coordination among the fund manager, retirement account custodian, and tax professional. More often than not, the retirement account owner and their financial advisor usually do not automatically receive a copy of the K-1. You must go out of your way to obtain a copy of the K1.
The administrative complications can become especially burdensome when an investment is sold. Previously suspended losses, partnership income allocations, and debt-financed gains may require specialized calculations to determine the appropriate tax liability.
I explored many of these complications in an earlier article, Why Owning a MLP in an IRA is a Bad Idea!, which discusses how Master Limited Partnerships (MLPs) can create unexpected tax liabilities within retirement accounts, along with the complications associated with Form 990-T and suspended UBTI losses.
Although MLPs and private equity funds are not identical investments, partnership-based investments can present similar UBTI concerns depending upon their structure and underlying activities.
Why We Believe These Tax Complications Matter
At Almega Wealth Management, we place considerable emphasis on tax-efficient investing. After all, an investor’s financial success is not determined exclusively by investment returns, but by how much wealth ultimately remains available after expenses and taxes. Understanding the tax consequences of private equity in retirement accounts before you invest in them is essential.
Consequently, we question the wisdom of introducing investments into retirement accounts when those investments may create unnecessary taxable income, additional administrative expenses, and restrictions on accessing capital.
Investment growth becomes considerably less attractive when the investment can trigger an unexpected tax bill within the retirement account.
For us, this represents yet another compelling reason to favor transparent, liquid, tax-efficient publicly traded investments over traditional private equity partnerships and other complicated alternatives.
About the Author: Bryan Wisda is the President of Almega Wealth Management. His career in finance spans more than 30 years. He has been a CERTIFIED FINANCIAL PLANNER™️ since 2006 and is a NAPFA-Registered Financial Advisor. Bryan is also an IRS Enrolled Agent. The IRS awards enrolled agent status as its highest credential. Unlike CPAs or attorneys who are licensed by individual states, EAs are licensed federally and can practice in any U.S. state. Bryan currently serves as a Board Member for the Institute for the Fiduciary Standard.