How to Hold a Carried Interest in a Roth IRA: A Self-Directed Guide to Fund Carry, IRS Rules, and UBIT Risk

A carried interest is one of the most powerful wealth creation tools available to investment professionals. When you pair that with a Roth IRA, where qualified distributions can be entirely tax free, the strategy becomes especially compelling. The idea is straightforward. If a carried interest can be owned by a Roth IRA, and that carried interest ultimately produces significant upside, the result may be long-term, tax free growth inside the retirement account.

But the execution is anything but simple.

Holding a carried interest in a Roth IRA sits at the intersection of partnership tax law, retirement account rules, prohibited transaction restrictions, valuation standards, and, when leverage is involved, potential exposure to Unrelated Business Income Tax or UBIT. The strategy is viable. However, it is highly technical and must be structured carefully.

This article walks through how investment funds are structured, how carried interest works, how a Roth IRA can legally own a carried interest using a Self-Directed Roth IRA, and where the real IRS risks lie. It also provides a balanced discussion of the UBIT and UDFI debate when a fund uses leverage, presenting both sides of the analysis so readers can understand both the opportunity and the complexity.

Investment Funds and How They Are Typically Structured

Most private investment funds, whether private equity, venture capital, private credit, or hedge funds, are organized as partnerships for federal tax purposes. The most common structures are limited partnerships or limited liability companies taxed as partnerships.

In a classic limited partnership structure, investors participate as limited partners, while the fund manager operates through a general partner entity. The limited partners contribute capital and receive distributions based on the fund’s performance. The general partner controls the fund’s operations, makes investment decisions, and is compensated for its services.

The partnership structure is favored because it allows income, gains, losses, and deductions to pass through to the owners without entity level taxation. Each partner receives a Schedule K-1 reflecting its share of the fund’s results.

What a Carried Interest Really Is

A carried interest is not a fee. It is a profits interest in the fund.

Typically, after investors receive back their contributed capital, and often after they receive a preferred return, the fund’s remaining profits are split between the limited partners and the carry holder, frequently on an 80/20 basis. The 20 percent share allocated to the carry holder is the carried interest.

The key feature of a carried interest is that it is subordinate. If the fund performs poorly, the carry may have little or no value. If the fund performs exceptionally well, the carry can be extraordinarily valuable.

Because of this subordinated and contingent nature, a carried interest often has little or no current fair market value at inception, even though it may later produce significant economic upside.

Separating Carry from Management Fees

Institutional funds almost always separate carried interest from management fees. Management fees are paid to a management company and are intended to cover operating expenses such as payroll, office costs, and overhead. Carried interest, by contrast, is allocated to a separate carry vehicle that receives profits only after investor hurdles are met.

This separation is not merely cosmetic. It clarifies economics, simplifies accounting, and helps avoid recharacterization risk. For retirement account investors, it is particularly important because management fees generally represent compensation for services, while carried interest is structured as an ownership interest in partnership profits.

Understanding the Roth IRA Advantage

A Roth IRA is one of the most powerful retirement vehicles in the tax code. Contributions are made with after tax dollars, but once the account satisfies the age and holding period requirements, qualified distributions are completely tax free. There is no required minimum distribution during the owner’s lifetime, and investment growth inside the account is not taxed.

When applied to traditional investments like stocks or mutual funds, the Roth IRA is already attractive. When applied to alternative investments with asymmetric upside, such as carried interests, the Roth IRA can be transformative.

The challenge is that most brokerage Roth IRAs are not designed to hold private partnership interests or carried interest vehicles.

Why a Self-Directed Roth IRA Is Required

To invest in private funds or to hold a carried interest, an investor must use a Self-Directed Roth IRA. A Self-Directed Roth IRA allows the account to own alternative assets, including private equity, venture capital, private credit funds, and partnership interests, subject to IRS rules.

In some cases, the Roth IRA invests directly into the carry vehicle. In other cases, the Roth IRA owns a special purpose LLC, often referred to as a checkbook control IRA LLC, which then holds the carried interest. This structure can simplify administration, but it must be set up correctly to avoid prohibited transactions.

Platforms like IRA Financial specialize in administering Self-Directed IRAs and Self-Directed IRA LLC structures, handling the custodial, reporting, and compliance aspects that traditional brokerage firms do not support.

How a Roth IRA Can Acquire a Carried Interest

From a mechanics standpoint, the Roth IRA, or its wholly owned LLC, acquires the carried interest in the same way any other investor would. The interest is issued or purchased by the Roth IRA at fair market value, and ownership is titled in the name of the Roth IRA or the IRA owned LLC.

The critical issues are valuation and prohibited transaction compliance.

Prohibited Transaction Rules and Fair Market Value

The prohibited transaction rules under Internal Revenue Code Section 4975 are designed to prevent IRA owners from using retirement funds for personal benefit. Transactions between an IRA and a disqualified person, which includes the IRA owner, must be carefully scrutinized.

In the context of carried interest, the key questions are whether the Roth IRA paid fair market value for the interest and whether the structure improperly shifts value to the IRA owner.

Because a carried interest is typically subordinate and contingent, its fair market value at inception is often modest. Valuation is commonly analyzed using a liquidation or waterfall method, asking what the carry would receive if the fund were liquidated at current values. In many cases, that value is very low.

Obtaining a third party valuation or a defensible valuation memorandum at the time of acquisition is a best practice. It provides contemporaneous evidence that the Roth IRA did not acquire the interest at less than fair market value.

The IRS, Valuation, and Enforcement Reality

A 2014 Government Accountability Office report discussed very large IRA balances and noted that certain assets, including carried interest like arrangements, can be difficult for the IRS to police. The report highlighted valuation challenges and acknowledged that enforcement in this area is complex.

One practical reality is the IRS statute of limitations. In most cases, the IRS has three years from the filing of a return to assess tax. Carried interests, by their nature, often have no meaningful value and generate no income for several years. By the time the carry becomes valuable, the statute of limitations on the original acquisition year may already be closed.

Even if the IRS were to argue that a prohibited transaction occurred at inception, the excise tax under Section 4975 is generally based on the amount involved, which is tied to the fair market value at the time of the transaction. In a properly structured carry, that amount is typically small. Taxes and penalties are not assessed on the later appreciation of the interest.

This does not eliminate risk, but it helps frame it realistically.

Roth Stuffing and Case Law Themes

The term Roth stuffing is often used to describe situations where assets with significant upside are placed into a Roth IRA at low value. The IRS has challenged some structures aggressively, but courts have not always sided with the government.

In cases like Summa Holdings, courts rejected broad IRS theories that attempted to rewrite transactions that complied with the statute. The takeaway is not that Roth planning is risk free, but that compliance with the Code matters more than optics.

Leverage, UBIT, and the Hardest Question of All

The most complex issue arises when the underlying fund uses leverage.

Unrelated Business Income Tax applies to retirement accounts when they earn income from an active trade or business or from debt financed property. When debt financed income is involved, it is referred to as Unrelated Debt Financed Income or UDFI.

The UBIT tax rate is the trust tax rate, which is steep. For 2025, the top marginal rate of 37 percent applies at relatively low levels of income. This makes UBIT exposure a serious consideration, even for Roth IRAs.

Using a C Corporation Blocker

To eliminate UBIT risk entirely, some investors interpose a C corporation blocker between the Roth IRA and the fund. The corporation pays tax at the current 21 percent corporate rate, and dividends to the Roth IRA are generally not UBIT.

This approach trades certainty for tax drag and added complexity. For some strategies, it is appropriate. For others, the cost outweighs the benefit.

Final Thoughts: Power, Complexity, and Discipline

Using a Roth IRA to hold a carried interest can be extraordinarily powerful. It aligns long term incentive economics with a tax free retirement vehicle. But it is not a casual strategy.

The real risks are not theoretical IRS hostility to Roth IRAs. They are practical. Valuation discipline, prohibited transaction compliance, leverage analysis, and careful drafting.

When structured properly, the strategy is defensible and widely used. When structured poorly, it can unravel quickly.