Many investors use exchange-traded funds to focus their investing. Fortunately, relatively few ETFs issue the complicated Schedule K-1 tax form; but, for those that do, it's important for investors to know the tax impact. Even in an IRA or other retirement account, an ETF that issues a K-1 can have devastating tax effects.

What Schedule K-1 is
K-1s are tax forms that investors receive if they are in partnerships and businesses that are treated like partnerships for tax purposes. The idea behind a K-1 is that partnerships themselves don't owe tax at the entity level; but instead, they pass through any taxable income or deductible expenses to their investors. Investors, in turn, must include those income and deductions on their own individual tax returns as appropriate.

Many investors dislike K-1s because they add a level of complexity to an individual tax return. Unlike a stock that simply pays dividends, K-1s can include several different types of income and deductions, all of which the taxpayer must account for on their returns, or else run the risk of audits. In addition, K-1 forms raise the possibility of having to file state tax returns in multiple states, especially for companies that earn income in multiple jurisdictions.

K-1s, retirement accounts, and unrelated business taxable income
At first glance, it might seem that holding an ETF that issues a K-1 in a retirement account would be a smart choice. In general, investors can ignore the tax consequences of most investments in IRAs and other retirement accounts, because those vehicles are tax deferred until the investor takes withdrawals from the retirement account.

However, owning a pass-through entity in a retirement account can lead to the income from the entity being treated as unrelated business taxable income or UBTI. Schedule K-1 will include any UBTI figure, and if the total UBTI for all investments in your IRA exceeds $1,000, then you'll need to prepare Form 990-T to submit to your IRA custodian for filing. You'll end up having to pay tax on the UBTI, even though you own the investment in a retirement account.

For the most part, having UBTI in your retirement account won't generally jeopardize its tax-exempt status. However, having too much UBTI in an IRA can be a red flag that could generate scrutiny from the IRS.

Just because you hold ETFs in an IRA doesn't mean that you can ignore the K-1 forms that those ETFs produce. In fact, ignoring K-1s from an IRA can be a huge mistake if it generates enough income to trigger income taxes.

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