It is generally assumed that income earned within a retirement account, including 401(k) and IRA accounts, is not taxable until the funds are distributed. This is not always the case.
A retirement account is a tax-exempt entity similar to charity or business league. To prevent tax-exempt entities from using their tax-exempt status to unfairly compete with a taxable entity, the law imposes an income tax on the taxable income of the entity that is unrelated to its reason for being tax exempt.
In the past couple of years I have been seeing more and more IRA accounts invested in certain publically traded limited partnerships that generate unrelated business taxable income. How can you tell if you have such investments in your IRA? Ask your broker. Look for partnership investments being listed in your periodic statements. If you are invested in a partnership, you will receive a Schedule K-1 from the partnership after the close of its year reporting your share of the partnership’s income, deductions and credits.
If your retirement account is invested in one of these partnerships, I strongly advise you to talk to your broker about selling the investment. The problem is that most of the investments are relatively small, and should there be an income tax reporting requirement for the retirement account, the cost of preparing and filing the necessary income tax return will usually far exceed any income generated by the investment.
A word to the wise.