Several months ago I published an article saying that it makes a lot of sense to put MLPs in an IRA. The article recognized that MLPs are tax advantaged vehicles, and that normally you put tax advantaged investments in a taxable account. However, if you don't have a taxable account, or you don't want to put more of the MLP in the taxable account, then it can still make a lot of sense to put the MLP in an IRA.
There were over 200 comments about this article and many of the comments said that putting MLPs in a IRA could result in significant tax to the IRA. Now that I've received my K-1s for the eight investment accounts that I manage (5 IRAs, 3 taxable accounts) I want to report on the actual facts that I've seen regarding having MLPs in taxable accounts.
In addition, one of the comments in the earlier article pointed out a mistake made about determining the amount of tax due, if any. This article describes and corrects that mistake.
None of my MLPs produced UBTI
As noted in the first article MLPs can generate Unrelated Business Taxable Income (UBTI), and the IRA itself will be taxed on the UBTI in excess of $1,000. The amount if UBTI that is subject to this tax is shown on line 20V of the K-1 that each MLP publishes. In total, I received 35 of these K-1s this year, since up to 5 MLPs were represented in each of the 8 investments accounts. The MLPs in question were:
- Breitburn Energy (NASDAQ:BBEP)
- Linn Energy (NASDAQ:LINE)
- Mid-Con Energy (NASDAQ:MCEP)
- QR Energy (NYSE:QRE)
- Vanguard Natural Resources (NASDAQ:VNR)
MLP investments in many of these accounts were small (actual annual distributions shown on line 19 were less than $1,000). For others, the investments were large (distributions over $10,000). Upon review of these K-1s, I found that the UBTI shown on line 20V of each of the 35 K-1s was negative.
In other words, the frequent warnings shown about tax on MLPs in IRAs was counterproductive, at least for these MLPs in the accounts that I examined. The MLP investments produced great returns that would have been very difficult to match if I had heeded the warnings and kept them out of the IRAs.
Putting the MLPs in IRAs allowed for enhanced returns
The tax-deferred nature of all IRA investments make them ideal for enhanced returns when secondaries are offered. As I explained in detail in these articles, MLPs frequently issue additional units to fund investments that increase the distribution per unit. The ability to buy additional units at the discounted price and sell them later when the unit price recovers produces extra returns over time that can add up significantly.
Taking advantage of secondaries can also be used in taxable accounts, but it can result in ordinary income when the units are later sold back. In some cases, frequent purchases and sales of MLP units will result in diminishing the tax advantages of holding MLPs in taxable accounts. Since this consideration is not applicable in IRAs, I normally avoid this additional trading in taxable accounts.
Some MLPs only belong in IRAs
I also noticed that BBEP, LINE, MCEP, and VNR generated little or no current taxable income in the taxable accounts. However, there was considerable taxable income generated by QRE. I don't know why this is true, but it was consistent among several accounts that had QRE. In particular the basic income amount shown on Line 1 of the K-1 for QRE was normally about 125% of the distribution amount shown on line 19.
I had QRE is two taxable accounts, one of the accounts was large and the other very small. In the large account Turbotax calculated taxable income equal to almost the full distribution. In the small account Turbotax determine taxable income even greater the amount of the distribution.
Based on these results, in the future I will be avoiding using QRE in taxable accounts. This quirk of QRE may be one reason for QRE's low price and unusually high yield (over 11%), but there are some basic fundamental reasons for the high yield as well.
The tax rate if there is UBTI
A comment by rlp2451 in the earlier article noted that I had shown the wrong table for computing the tax rate on UBTI. As rlp2451 correctly noted, if an IRA has any UBTI in excess of $1,000 then the excess is taxed using the following table.
|of amount over 0|
|2,400||5,600||360 + 25%||of amount over 2,400|
|5,600||8,500||1,160 + 28%||of amount over 5,600|
|8,500||11,650||1,972 +33%||of amount over 8,500|
|11,650||3,011.50 + 35%||of amount over 11,650|
Please note that if there is more than one MLP in an IRA, then the UBTI amounts for the various MLPs are combined, and a net UBTI is determined. Negative UBTI from one MLP is used to offset positive UBTI from another MLP. If the net UBTI is greater than $1,000 then this excess is taxed using the above table.
Fortunately, my broker (Schwab) does all of these calculations for me. Then Schwab prepares, signs and files a form 990-T for each IRA. If a tax was due then that tax would be directly paid out of the IRA. In my case, at least this year, no tax will be due because all the UBTI amounts shown on line 20V were negative.
I expect the UBTI for next year to be negative as well for these MLPs, but I will be watching. If UBTI is ever positive, then I will factor that into my decision about keeping the investment. Until then, I have plenty to consider based on the fundamentals themselves.