MLPs: Good Investment, Lousy Choice for an IRA

Question: I've heard that I should always try to keep my income-producing investments (bonds, real estate, dividend-paying stocks) inside my IRA to avoid having to pay taxes on each income distribution. But it sounds like master limited partnerships are an exception to the rule? And does that mean they're a good bet for my taxable account? Please explain.

Answer: MLPs have inspired a lot of discussion on Morningstar.com recently, with many readers enthusing about their generous income streams amid the current, low-yielding environment. But you're right--their tax treatment is cumbersome no matter where you hold them, and they're not well suited being held within an IRA. That can make them a headache for retirees, many of whom hold the bulk of their investment assets in an IRA wrapper.

Why It's Good to Be an MLP
Before delving into the specifics of how the Internal Revenue Service treats income received from an MLP, let's first review what master limited partnerships are. In short, they're partnerships that trade on a public exchange.

As businesses, MLPs have an important advantage over corporations: They don't pay taxes at the company level but instead at the partner, or unitholder, level. That stands in contrast with corporations, which pay taxes at the company level and again at the shareholder level when their dividends are taxed.

To qualify for this favorable tax treatment, MLPs must generate 90% of their income from what the IRS considers to be qualified sources--in the case of most MLPs, that means producing, processing, and especially transporting energy products. The vast majority of MLPs operate in the energy sector, and many MLPs run pipelines that move natural gas and other energy products around the country.

Master limited partnerships have caught the eye of many income-oriented investors because their payouts can be compelling: Yields routinely run as high as 6%, 7%, or even higher. The fact that MLPs can skirt taxes at the business level has a helping hand in boosting the income they can pay out to their unitholders.

An even bigger factor behind MLPs' lush yields, however, is that once a pipeline is up and running, MLPs have little in the way of ongoing capital investment but a lot in the way of cash flows. That means that most of their income can flow through to the partners in the business. Those cash-flow-generating properties are a big reason why Morningstar's resident dividend guru, Josh Peters, believes that MLPs can be a valuable part of income-seeking investors' toolkits.

Tax Treatment
Despite their favorable tax treatment as businesses, MLPs' tax treatment for unitholders is completely different than is the case for owners of stocks, bonds, and mutual funds. That can create a bit of extra paperwork, and in some cases tax headaches.

For starters, MLPs' payouts aren't actually dividends but are instead called distributions. So instead of receiving a 1099 form that documents the income received from an investment, MLP holders receive what's called a K-1, documenting any income the MLP has kicked off as well as the unitholder's share of the MLP's gains or losses. And because the MLP owns depreciating assets such as pipelines, the K-1 will also specify any depreciation allowances associated with all that capital equipment.

One of the big advantages of that depreciation allowance is that most of the income the unitholder receives is considered a return of capital in the IRS' eyes, which in turn reduces the investor's cost basis in the MLP. In practical terms, that means that the investor will have to pay taxes on the spread between a lower purchase price and the MLP's price at the time of the sale, but most of the income the MLP kicks off from year to year won't be taxable. The portion of an MLP's income distribution that is not considered a return of capital is taxed as ordinary income for the tax year in which it was received. That tax treatment makes MLPs pretty attractive for investors in taxable accounts relative to other income-producing investments, where any income is taxed in the year in which you receive it.

On the flip side, the tax treatment of MLPs held in IRAs and 401(k)s is quite ugly. With most investments held inside an IRA or 401(k), account owners don't have to pay taxes on any income or capital gains paid out from year to year. Instead, they won't owe any tax on their accounts until they begin taking distributions during retirement. By contrast, the IRS considers cash distributions from MLPs held inside a tax-deferred account as unrelated business taxable income. If the UBTI distributions are small or even negative, no problem--you won't owe tax and you can even use them to cancel out UBTI from other MLPs. But if by chance total UBTI distributions exceed $1,000, your IRA custodian must file IRS form 990T, and any amount of UBTI over that threshold is taxable. (IRS Publication 598 supplies additional details.)

So to sum up, holding an MLP in a tax-deferred account is a bad idea on a couple of levels. First, you'll pay income tax on distributions that exceed $1,000, and you'll also pay tax when you begin taking withdrawals from your account during retirement. Second, you won't be availing yourself of MLPs' benefits when held within a taxable account.

Alternatives
For all those reasons, we wouldn't recommend holding individual MLPs inside an IRA (traditional or Roth), 401(k), 403(b) or 457. For investors determined to get an MLP inside a tax-deferred wrapper, one option would be to consider one of the new exchange-traded note products that focus on the MLP industry. These ETNs aim to track the performance of a basket of MLPs, so they provide a valuable level of diversification. My colleague Paul Justice discussed the pros and cons of both MLP ETNs and exchange-traded funds in this article.

Additionally, the ETN wrapper helps shareholders who own it within the confines of an IRA circumvent the UBTI problem, thereby avoiding the double taxation that hits other owners of MLPs inside IRAs. MLP taxation remains devilishly complicated, though, so check with a tax advisor before adding an MLP or MLP ETN to your account. Also consider valuations: Following a spectacular runup during the past year, most MLPs in our stock analysts' coverage universe are fairly valued to slightly overvalued currently.

A version of this article appeared on May 11, 2010.

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