Can There Be Taxes on My IRA or 401(k) Investments?
Most of us think about IRA and 401(k) retirement plans as being completely tax-sheltered. So many investors are shocked when they learn that this isn’t entirely true.
Some types of investments made within an IRA can create a tax liability for the IRA.
Within the narrow scope of investing in common financial products, there are no tax implications for a tax-exempt retirement plan. This is the framework most of us are used to, and why the concept of taxes in an IRA is disconcerting.
With a self-directed IRA, you have the flexibility to invest much more broadly. This flexibility opens the possibility of certain transactions where taxation can apply inside of a normally tax-sheltered entity.
An IRA or 401(k) creates taxable income in two cases:
- When using debt-financing, and
- When engaging in a trade or business
The fact that an IRA transaction may have a tax cost doesn’t necessarily rule out an investment as a great way to grow your retirement savings. Many very profitable types of investing are taxable, but if the post-tax returns are better than average, your IRA can still come out ahead.
Misinformation About IRA Taxes
Not surprisingly, the fact that taxes can exist inside of an IRA creates all kinds of confusion.
The amount of bad information circulating on this topic is mind-boggling, and spans the spectrum from the unfounded fears of the misinformed to false assumptions and factual misstatements to shady strategies for tax avoidance.
But it doesn’t need to be this way. With a little bit of effort and expert guidance, you can obtain a solid understanding of the possibility of taxes inside your IRA, and strategize appropriately.
Alphabet Soup
Understanding the industry language is the key to understanding this concept.
Where we see folks get the most confused is by information that uses the wrong terminology and mixes concepts. There are three key acronyms associated with taxes inside an IRA:
1. Unrelated Business Income Tax – UBIT
This is simply the name of the tax paid when a tax-exempt IRA engages in an activity that creates tax exposure.
UBIT is similar to “Income Tax”, in a personal sense. There are a lot of different types of activities that create income tax, with different rules in terms of applicability, deductions, etc.
The same is true with UBIT in the tax-exempt space.
UBIT is often the one and only word used to describe this whole field. That isn’t precise, and is a big cause of confusion for retirement investors.
2. Unrelated Business Taxable Income – UBTI
UBTI is a type of income generating activity that creates tax exposure.
When a tax-exempt entity engages in a trade or business activity on a regular or repeated basis, it’s deemed to be creating UBTI. Flipping houses is a common example of a dealer activity considered to be a trade or business in the real estate space.
After dealing with the income, exemption, and deduction logic of a tax return, the tax paid on UBTI will be in the form of UBIT.
3. Unrelated Debt-Financed Income – UDFI
UDFI is generated when a tax-exempt entity uses debt-financing. A common example would be an IRA using mortgage financing to acquire a rental property.
After dealing with the income, exemption, and deduction logic of a tax return, the tax paid on UDFI will be in the form of UBIT.
When we examine topics of taxation inside of an IRA, it’s important to focus on the type of income generating activity. Each activity has different applications and different implications for an investor.
Non-Taxable Activities
There are, of course, a whole range of investment activities that an IRA can engage in without any tax implications.
For many investors, understanding where this line is drawn and staying on the non-taxable side of the line is the preferred approach. This can be the correct approach. Simple is good.
Passive, non-leveraged investments won’t be taxed. Passive investments include:
- Interest from note instruments
- Rent from real property
- Dividends
- Royalties
- The eventual sale of an asset that has been held over time to produce such passive income.
Investing in notes, whether directly as a lender or into a note fund is a very popular form of investing with a self-directed IRA. Interest is passive in nature, and not subject to taxation.
Many investors like to purchase rental properties using all cash with an IRA or Solo 401(k). Income from rental cash flow is passive, and therefore fully sheltered (as is any future gain on sale if the property appreciates over time).
Investing in a private company that operates as a subchapter C corporation will produce dividend income, which is also passive. This is much like investing in publicly-traded companies in the stock market.
Tax on Debt-Financed Investments – UDFI
Leverage is a powerful tool for investors.
If you can use $100,000 of your IRA to make a down payment on a $200,000 property, your IRA will make more money than if it simply purchased a $100,000 property using all cash — even after considering the costs of the borrowed money.
With a self-directed IRA, you can apply this classic investing principle and use leverage to accelerate the growth of your tax-sheltered retirement savings.
Let that sink in for a moment.
However, this power to use leverage introduces a small tax cost. The percentage of the income that the IRA receives as a result of the non-IRA money is considered to be UDFI and subject to taxation.
With a property that is 60% debt-financed, that means 60% of the gross income is taxable. The IRA then gets to apply the same 60% ratio of allowable deductions like depreciation, interest on the note, property taxes, etc. to reduce the amount of table income.
The end result is that a small portion of the overall income generated by the property becomes taxable, and the tax hit is generally not significant.
If you browse the internet for information on UDFI, however, you’ll frequently see incorrect statements indicating that if you use 60% debt-financing, 60% of your income is taxed at the maximum UBIT rate of 37%.
This simply isn’t true… but it would certainly be a disincentive to research the concept further if you took that bad information at face value.
A while back we performed an analysis on the use of a non-recourse mortgage to purchase a $200,000 rental property as compared to making an all cash purchase on a $100,000 property. Over a 5-year hold, the leveraged investment produced an additional $78,000 of return at a tax cost of $4,700.
If you were to say: “Taxes are going to cost me $4,700”, that sounds bad. Many investors might balk at that point.
When you look through the tax cost and see the significant $78,000 boost in overall return from the investment, it’s a no-brainer. Leverage wins!
We recently analyzed an IRA investment into a leveraged real estate syndication and found similar results. Tax on UDFI reduced annual returns by about .5% on average during the hold period.
Thanks to the use of leverage, the returns were above 14% even after the tax hit. A stable investment in real property producing 14% or better returns is a good thing.
The Solo 401(k) Exemption to UDFI
Tax on Unrelated Debt-Financed Income applies to both IRA and Solo 401(k) plans. A great thing for some real estate investors is that 401(k) plans have an exemption for debt-financed income where the debt is used for the acquisition of real property.
For investors looking to have their plan purchase a rental property using mortgage financing, or to participate as a limited partner in a leveraged multifamily real estate syndication, this exemption is a real benefit.
A 401(k) plan will get to keep 100% of the leveraged return without the cost of taxation. More importantly, the administrative burden of having your retirement plan file a separate tax return is eliminated.
For investors who qualify for a Solo 401(k), this exemption from UDFI is one of many reasons the Solo 401(k) can be a superior self-directed retirement plan format.
Tax on Trade or Business Activities – UBTI
With UDFI, we typically see a small tax cost in exchange for a significant benefit in overall investment return.
When a tax-exempt entity engages in a trade or business on a regular basis and therefore creates Unrelated Business Taxable Income, the tax implications may not be so trivial. Great care must be taken with evaluating UBTI generating investments.
The principal behind UBTI is to level the playing field and protect tax-paying businesses from unfair competition.
Common examples of activities that create UBTI include:
- Active real estate transactions such as flipping, wholesaling, or new construction for immediate sale.
- Venture capital and other forms of private equity investments with a direct equity stake in a pass-through entity such as a LLC or LLP. (Dividend income from a subchapter C corporation is passive).
- Any kind of dealer activity comprised of simply buying and reselling assets.
- Direct ownership in an operating business taxed as a pass-through.
UBTI is the net income produced by such activities after allowing for deduction of normal expenses. The trust tax rates that apply to an IRA or 401(k) rapidly scale up to 37% at income levels over $12,750. As such, the amount of UBIT paid can be significant.
When evaluating investments that create UBTI, there are a few key questions to consider.
What will the impact of UBIT be?
In some cases, with very profitable ventures, the net-after-tax returns can still be quite good and perhaps better than other investments your IRA may be participating in today.
Put another way, while an IRA may not be the most tax-efficient way to accomplish a certain type of deal – that deal may be better for the IRA than other options.
What type/portion of income from the investment will be UBTI generating?
UBTI applies to operating income, not to equity gain. In a true venture capital play where the prize is selling the IRA’s stake in the company for a higher price than what was paid originally, the fact that some of the operating income occurring between the purchase and sale is taxable may be inconsequential.
This is especially valid in a startup where income in initial years may be negative, providing write-offs for income in future years.
If the benefit of making the investment in a business is the ongoing operating income the business will produce, however, then UBTI will likely spoil the opportunity.
Tax Filings
When an IRA or Solo 401(k) generates taxable income, the plan is the taxpayer and must file a separate return using IRS form 990-T.
UBIT has no intersection with your personal tax return. It’s your obligation as the IRA or 401(k) account holder to arrange for return preparation and filing.
It’s a best practice if you intend on investing in ways that will generate UDFI or UBTI that you meet with your licensed tax professional in advance. They will help you to properly gauge the tax implications of a planned strategy, and guide you with respect to the records they will need from you in order to prepare the tax return.
Not all tax professionals are familiar with the issues surrounding taxation in a retirement plan. Fortunately, these same tax matters apply to all tax-exempt entities such as religious organizations, hospitals, educational institutions, etc. Any tax provider familiar with these classes of entities should be able to assist you.
In Summary
Hopefully we’ve helped clarify some of the basic principles surrounding taxation on UDFI and UBTI inside of a self-directed retirement plan.
The key takeaway for us has always been to look through the tax itself and evaluate the overall risk/reward of a given investment.
If an opportunity will be more secure and produce better income than non-taxed alternatives, it may be worth pursuing.
That said, if you have a choice between two investments that will produce similar returns, with one having UBIT exposure and the other not, the simplicity of the non-taxed opportunity may make that the better option.
Helpful Resources
IRS Publication 598 – Tax on Unrelated Business Income of Exempt Organizations
U.S. Code § 512 – Unrelated Business Taxable Income
U.S. Code § 514 – Unrelated Debt-Financed Income
IRS Form 990-T – Exempt Organization Business Income Tax Return
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Quick answers to common questions
We’ll take you through a simple, step by step process designed to put your investment future into your own hands…immediately. Everything is handled on a turn-key basis. You take 100% control of your Retirement funds legally and without a taxable distribution.
YES! In 1974, Congress passed the Employee Retirement Income Security Act (ERISA) making IRA, 401(k) and other retirement plans possible. Only two types of investments are excluded under ERISA and IRS Codes: Life Insurance Contracts and Collectibles (art, jewelry, etc.). Everything else is fair game. IRS CodeSec. 401 IRC 408(a) (3)
It’s actually pretty simple. Early on, regulators let the securities industry take the lead in educating the public about retirement accounts. Naturally, brokers and banks promoted stocks, bonds, and mutual funds—giving the impression that those were the only allowed investments. That was never true... and still isn’t. You can probably guess why they kept the rest under wraps.
It is possible to use funds from most types of retirement accounts:
- Traditional IRA
- Roth IRA
- SEP IRA
- SIMPLE IRA
- Keogh
- 401(k)
- 403(b)
- Profit Sharing Plans
- Qualified Annuities
- Money Purchase Plans
- and many more.
It must be noted that most employer sponsored plans such as a 401(k) will not allow you to roll youraccount into a new Self-Directed IRA plan while you are still employed. However, some employers will allow you to roll a portion of your funds. The only way to be completely sure whether your funds are eligible for a rollover is by contacting your current 401(k) provider.
A Solo 401(k) requires a sponsoring employer in the format of an owner-only business. If you have a for-profit business activity – whether as your main income or as a side venture – and have no full-time employees other than potentially your spouse, your business may qualify. The business may be a sole-proprietorship, LLC, corporation or other entity type.
A self-directed retirement plan is a type of IRA or 401(k) that gives you greater control over how your retirement funds are invested. Unlike traditional accounts held at banks or brokerage firms that limit you to stocks, bonds, and mutual funds, self-directed plans allow you to invest in a wide range of alternative assets including real estate, private businesses, precious metals, cryptocurrency, and more.
These plans still follow the same IRS rules and maintain the same tax-deferred or tax-free benefits as conventional retirement accounts. The difference is simply in how and where you choose to invest.
No. Moving to a self-directed IRA or Solo 401(k) does not trigger any taxes, as long as your funds are eligible for rollover.
Self-directed retirement plans maintain the same tax-advantaged status as traditional plans offered by banks or brokerage firms. The key difference is flexibility—our plans are designed to give you greater control and allow for a wider range of alternative investments beyond stocks, bonds, and mutual funds.
A prohibited transaction is any action between your retirement plan and a disqualified person that violates IRS rules and can lead to serious tax consequences. Under IRS Code 4975(c)(1), prohibited transactions include:
- Selling or leasing property between your plan and a disqualified person Example: Your IRA cannot purchase a property you already own.
- Lending money or extending credit between the plan and a disqualified person Example: You cannot personally guarantee a loan your IRA uses to buy real estate.
- Providing goods or services between your plan and a disqualified person Example: You can’t use your personal furniture to furnish a rental property owned by your IRA.
- Using plan income or assets for the benefit of a disqualified person Example: Your IRA cannot buy a vacation home that you or your family use.
- Self-dealing by a fiduciary (using plan assets for their own benefit) Example: Your CPA shouldn't loan your IRA money if they’re advising the plan.
- Receiving personal benefit from a deal involving your IRA's assets Example: You can’t pay yourself from profits your IRA earns on a rental.
If a transaction doesn’t clearly fall within the allowed guidelines, the IRS or Department of Labor may review the situation to determine if it qualifies as a prohibited transaction.
Disqualified persons are individuals or entities that are prohibited from engaging in certain transactions with your IRA or 401(k). Doing so could trigger a prohibited transaction, which may result in taxes and penalties.
Here’s who is considered a disqualified person:
- You (the account holder)
- Your spouse
- Your parents, grandparents, and other ancestors
- Your children, grandchildren, and their spouses
- Any advisor or fiduciary to the plan
- Any business or entity owned 50% or more by you or another disqualified person, or where you have decision-making authority
These rules exist to prevent self-dealing and ensure your retirement plan remains in compliance with IRS regulations.
(Reference: IRC 4975)
Understanding and following these rules can be tricky, but it’s very doable. The best way to stay compliant is to work with professionals who specialize in self-directed retirement plans. They can help you navigate IRS guidelines and avoid prohibited transactions.
If an IRA holder is found to have engaged in a prohibited transaction with IRA funds, it will result in a distribution of the IRA. The taxes and penalties are severe and are applicable to all of the IRA’s assets on the first day of the year in which the prohibited transaction occurred.
Yes. While self-directed retirement plans allow for a wide range of investments, there are a few important restrictions.
You cannot invest in collectibles or life insurance contracts, and you must avoid prohibited transactions—activities that benefit you personally rather than the retirement plan. These include things like buying or selling property to yourself or family members, using plan assets for personal gain, or self-dealing in any way.
Violating these rules could cause your entire IRA to lose its tax-advantaged status. To protect your account, it’s essential to work with professionals who understand IRS regulations and can help you stay compliant.
This is a common misconception. In many cases, professionals may simply be unfamiliar with self-directed retirement plans, as they fall outside their usual scope of work. CPAs and tax preparers are trained to file taxes, not necessarily to advise on alternative retirement strategies. Financial advisors and brokers often work for firms that focus on traditional investments like stocks and mutual funds—and may not benefit from or support alternative options like real estate or private lending.
Self-directed retirement investing is legal under IRS rules—but like any specialized area, it requires working with professionals who understand how it works.
The IRS has rules in place to make sure your IRA is used only for the exclusive benefit of the retirement account—not for personal gain or to help family members. These rules can get complicated because there are many ways a conflict of interest can occur, even unintentionally.
For example, if your IRA buys a house and rents it to your mother, you might be reluctant to evict her if she stops paying rent. That emotional connection creates a conflict between what’s best for your IRA and your personal relationships, something the IRS aims to prevent.
These rules help ensure your retirement account stays compliant and protected. (See IRC 408)
Yes. Most tax-deferred retirement accounts—such as Traditional IRAs, old 401(k)s, 403(b)s, and TSPs—can be rolled over into a self-directed IRA or Solo 401(k), depending on your eligibility. Roth IRAs cannot be rolled into these accounts.
You can contribute directly from earned income, subject to annual IRS contribution limits. The method and amount depend on the type of plan you have (e.g., Solo 401(k) vs. IRA).
To take a distribution, you'll request funds through your custodian or plan administrator. Distributions may be taxable depending on your account type and age. Early withdrawals may be subject to penalties.
For 2025, the Solo 401(k) max contribution limit is $81,250 if age 60-63, $77,500 if age 50-59 or 69+, and $70,000 if under 50. Traditional and Roth IRAs have a limit of $7,000 ($8,000 if age 50+). Limits are subject to IRS adjustments.
Yes. IRA contributions are typically due by your personal tax filing deadline (e.g., April 15). Solo 401(k) contributions follow your business tax filing deadline, including extensions.
IRS reporting requirements vary depending on the type of self-directed retirement plan you have. Here’s a quick breakdown of what you need to know
Please note: Our team can help you understand what’s required for your specific account, but we don’t provide tax or legal advice. We always recommend working with a qualified tax professional to ensure full IRS compliance.
Self-Directed IRA (Traditional or Roth)
- Form 5498 – Filed by your custodian each year to report contributions, rollovers, and the fair market value (FMV) of your account.
- Form 1099-R – Issued if you take a distribution or move funds out of your IRA.
- Annual Valuation – You'll need to provide updated FMV for any alternative assets held in the account, such as real estate or private placements.
Solo 401(k)
- Form 5500-EZ – Required if your plan assets exceed $250,000 as of year-end. Must be filed annually by the plan participant.
- Form 1099-R – Required if you take a distribution or roll funds out of the plan.
- Contribution Tracking – Keep records of employee and employer contributions. These are not filed with the IRS but may be needed for tax reporting or audits.
SEP IRA
- Form 5498 – Filed by your custodian to report contributions and FMV.
- Form 1099-R – Filed by your custodian. Issued for any distributions.
- Employer Contributions – Must be reported on your business tax return (and on employee W-2s, if applicable).
Health Savings Account (HSA)
- Form 5498-SA – Filed by your HSA custodian to report contributions.
- Form 1099-SA – Filed by your HAS custodian. Issued for any distributions.
- Form 8889 – Must be included with your personal tax return to report contributions, distributions, and how funds were used.
