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UBIT, Margin Accounts and the Solo 401k

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Will you pay UBIT if your Solo 401k opens a margin account? When you’re weighing retirement account options, one question stands above the rest. Yes, you want a good return on investment and yes, you want to know how exactly you can move that money around. But first, you need to know what the tax laws say.

Things can get confusing, especially if you’re considering alternative ways to invest. For some people, those alternative methods mean they end up paying the Unrelated Business Income Tax. But what are the rules for the UBIT? And if you invest in a Solo 401k, do you have to pay the tax, even if you have a margin account for the Solo 401k? Let’s take a look.

What is UBIT?

UBIT was set up as a way to level the playing field, so to speak. When you invest in an IRA or 401k plan, those accounts are tax deferred, meaning you don’t pay taxes until distributions start.

Most people invest in “passive” options like the stock market, so the UBIT doesn’t apply. But if you want to invest that money in an active business or a startup, it’s perfectly legal, but the government argues you have an unfair advantage.

You’re launching a business with tax deferred money, after all, while other would-be investors have to pay taxes on their portion. To balance things out, the Internal Revenue Service created the UBIT, requiring people to pay a tax on $1,000 or more of net income generated each year from that investment.

The rules are pretty clear. You have to pay a UBIT if your investment meets three qualifiers.

First, your investment earns income directly from a business activity. Second, that business activity is regularly carried on by an organization and third, that business is not related to any company’s tax exempt status. Let’s say you used that retirement account to invest in a local restaurant through a partnership or limited liability company. The restaurant turns out to be profitable and you start getting a return on that investment. As a result, you qualify for UBIT, because that income is from an operating company, one that’s not tax exempt. It even applies to charities and other non-profits, as IRS officials explain here.

Setting the Margins

What if you don’t have a traditional IRA? What if you have a Solo 401k plan and invest it in a margin account? The answer is still the same. Yes, even for margin accounts, you have to pay a UBIT fee. In fact, a tax court case set a legal precedent where a tax-exempt trust (501c organization) had to pay UBIT on a stock margin account in Bartels Trust v U.S. In fact, the Court of Appeals for the Federal Circuit asserted that even though the trust was not engaged in a business, the income from securities bought on margin would still be subject to UBIT.

The rules are the same, regardless if you invest in a traditional or alternative plan. And if you’re confused confused about who qualifies for a Solo 401k plan, we can answer that here. And if you have questions about the Roth or other IRA plans, here’s some answers for that.

But what is a margin account? And how is it different from other investment plans?

A margin account is created when a brokerage firm lets investors borrow money to buy stock. The money isn’t free, as the firm charges an interest rate, just like a credit card or any other debt. How much can you borrow? The law allows for you to borrow up to 50 percent of the overall purchase price. Let’s say you want to buy $40,000 in stock from a company, but your Solo 401k only has $20,000 in it. You can borrow up to the remaining $20,000 from the firm. Now, notice we said the law allows up to 50 percent. That’s the maximum amount allowed. Any investment firm can lower the amount they’ll allow you to borrow.

Margin Accounts and the Solo 401k

But if you want to open margin accounts, then there are a few things you need to be aware of. First off, most companies won’t let people create margin accounts with a Solo 401k plan, so check with an expert who can help. Many groups also warn people to be careful with margin accounts in general. When investments are rising in value, trading on margin can be a benefit. But you’re still responsible for that borrowed money, even if the stock crashes and you lose your investment. You just need to be careful not to borrow more than you can afford.

With that in mind, before you invest, it’s important not just to know what the UBIT is, but understand the rate you’re being charged. Always work with a CPA and/or tax advisor who can help you prepare IRS form 990-T if you owe UBIT and calculate and prepare the tax return for the affected income.

Above all, just make sure you understand the costs before moving forward. You don’t have to do that alone. The IRS offers more information here and we can answer more questions elsewhere on the blog.

One Response

  1. Please confirm that UBIT applies in the same way capital gain is taxed — that is, if you purchase stock on margin, gain is subject to UBIT when you sell the stock? What if you continue to contribute to the account and/or sell other stocks not purchased on margin and pay off the margin before you sell the stock? Does UBIT still apply? Thank you.

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