Master Limited Partnerships (MLPs) have grown extremely popular in this low-rate environment, as investors seek yield, diversification and steady returns. But investors may want to think twice about holding MLPs in retirement accounts such as 401(k)s and IRAs due to complex tax issues.
MLPs are publicly listed firms involved in the processing, storage and transportation of energy commodities such as oil and natural gas. At the end of April, there were more than 102 publicly traded energy MLPs with a combined market cap of about $400 billion, according to Alerian.
Many MLPs are paying dividend yields of 5% or more – hence their popularity with income-oriented investors.
But the tax treatment of MLPs is tricky. The partnerships themselves do not pay federal or state corporate income taxes. Investors in MLPs receive a Schedule K-1 rather than a Form 1099, which can create headaches. Investors may also have to pay taxes in each state in which the MLP operates.
And most of the income investors receive from MLPs is not taxed as dividends. “The bulk of the distributions from individual MLP holdings is considered a return of capital, which is not an immediate taxable event, but reduces an investor’s cost basis,” according to investment researcher Morningstar. “Upon sale of the MLP, an investor pays capital gains taxes based on a (typically) lower cost basis.”
Yet holding MLPs in 401(k) accounts or IRAs may actually cause more harm than good, in terms of taxes. “Investments that provide a K-1 to investors should not be held in any tax advantaged accounts – though many people seem to do it anyway,” says Philip Trinder, who manages the MLP Protocol Sprint investment portfolio on Covestor.
MLP income could be considered unrelated business taxable income (UBTI), and investors in retirement accounts will have to pay taxes if UBTI tops $1,000 in a year.
In an IRA or 401(k), the income is already tax-deferred, so the tax benefits of MLPs aren’t as appealing, according to the National Association of Publicly Traded Partnerships. “The MLP’s business is not related to the retirement account’s tax-exempt purpose; therefore the IRA’s share of the MLP’s income is treated as UBTI and is taxed accordingly,” according to the trade association.
Investors are understandably hungry for income, but it’s important to do your homework before stretching for yield.
DISCLAIMER: The information in this material is not intended to be personalized financial and/or tax advice and should not be solely relied on for making financial decisions. Please note that the information being provided is strictly a courtesy. Investments in MLPs include the risks of declines in energy and commodity prices, decreases in energy demand, adverse weather condition, natural disasters, and changes in tax laws.
