While individual retirement accounts typically hold paper investments like stocks and bonds, you aren't limited to those. Your IRA can also hold precious metals, real estate or even oil and gas royalties. These are investments that pay you income based on the production of oil and gas wells. While royalties are sometimes popular for their tax benefits, their cash flow can also make them an appropriate choice for your IRA.
Most regular IRA custodians limit your choices to easy-to-administer paper investments, even though the Internal Revenue Service's rules give you broad latitude on what you can include in your retirement account. Therefore you will need to open a self-directed IRA to invest in nontraditional investments like oil and gas royalties. These accounts are set up by investment companies that make sure your holdings comply with IRS rules, but the custodians don't tell you how to invest your money. Instead, you deposit your funds with them and they invest the cash based on your direction.
Traditional vs. Roth
You can put your royalties in a traditional or Roth IRA. With a traditional account, the money you put in isn't usually taxed but you pay regular income taxes on all of the cash you take out when you retire. A Roth IRA is the opposite -- you contribute taxable money today, but everything you take out in retirement is tax-free. When deciding which type of IRA to use, ask yourself whether you think your tax rate is higher now than it will be in the future. If you expect your rate to go down, a traditional IRA may be the better option. If you anticipate having significant income in retirement that will bump you into a higher tax rate, a Roth may be a better option for your royalties.
When you put oil and gas royalties into an IRA, you lose access to one of the account's biggest benefits. Many investors buy royalty investments in their taxable accounts because they are able to shelter some of the income from taxes, using the "depletion" allowance. Depletion is an accounting tool that takes into account the likelihood that the well will run dry. For example, if your royalty is based on $50,000 of gross income, and you claim a 15 percent depletion allowance, the first $7,500 of your royalty payments would be tax-free. When you invest in a tax-free or tax-deferred account, you lose the benefit of the depletion tax shelter.
When you hold leveraged assets in your IRA, you could be subject to a special tax on unrelated business taxable income. The IRS gives your IRA income a temporary or permanent exclusion on taxes, but if an IRA investment uses debt to increase its return, that extra return from the additional borrowed money isn't included in the favorable tax treatment. If a royalty investment includes leverage, the portion of its return that comes from leverage will be subject to UBTI.
- IRS: Traditional and Roth IRAs
- IRS: Publication 535, Business Expenses
- Ronald J. Cappuccio, L.D., LL.M. (Tax): Going the Non-Traditional Route
- R. King and Co.: Oil and Gas Royalty Income Taxes
- Blackbeard Data Services: Oil & Gas Investing FAQ
- Oil and Gas Financial Journal: Some Simple Rules for Investing in Oil and Gas Private Placements
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