Please ensure Javascript is enabled for purposes of website accessibility

What Are the Tax Effects of K-1s Issued by ETFs in IRAs?

By Motley Fool Staff – Feb 21, 2016 at 10:48PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

There are potential pitfalls of K-1 income in a retirement account. Learn about them here.

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.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now


Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 10/06/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.