Fitting MLPs Into Your Retirement Account

Includes: AMJ, EEQ, KMP
by: Avi Morris

MLPs have superior long term growth records making them excellent candidates for investment in retirement accounts with long term time horizons. MLPs are primarily yield securities with values heavily influenced by their preferred tax status. Retirement accounts also have a preferred tax status. Before committing funds to MLPs in a retirement account, 2 important considerations need to be understood: tax issues and potential costs by the fund custodian (typically a brokerage firm or bank).

Distributions from MLPs generate unrelated business taxable income (UBTI) in a retirement account. If UBTI exceeds $1000 in a year, it is subject to tax and T990 forms must be filed by the custodian (which will generate a fee). Tax is paid from assets in the retirement account. An owner would then be taxed twice, yearly taxes and when money is withdrawn in later years. These tax issues are complicated. Your tax advisor should be consulted to advise how tax issues and fees affect your unique retirement account. My brokerage firm does not allow MLPs in a retirement account, its way of eliminating potential problems.

However some investors purchase MLPs for retirement despite the bother and fees, attracted by superior rates of return. The most basic measure for MLP growth is the supplemental Alerian MLP Index including reinvested income. It has risen from 100 to 1056 in 15½ years, equivalent to a compounded annual growth rate over 16%. While the past track record is no guarantee of future performance, it is unusually impressive when compared with some of the bluest chip companies that were Dividend Aristocrats 15 years ago. For example, in 1993, I purchased Coca Cola (NYSE:KO) in my IRA. With reinvested dividends, the investment has risen almost 5 fold. Good but far short of the MLP index. Investments in other Dividend Aristocrats (along with non Dividend Aristocrats) have done worse.

For those who would like to invest retirement money in MLPs without buying units in partnerships, there are alternatives. A few closed end and open end funds invest in MLPs. Additionally, a number of funds track the Alerian MLP Index or segments of the index. One ETN, JPMorgan Chase Capital XVI (NYSEARCA:AMJ), tracks the Alerian MLP Index. Even with reinvested income, it will not truly emulate the index with reinvested income because management fees are deducted. AMJ yields 5.4% based on the May coupon (dividend), less than the 6.3% yield on the index. A direct way to participate in MLP growth is by purchasing shares in Kinder Morgan Management (NYSE:KMR) or Enbridge Energy Management (NYSE:EEQ). Each MLP has a stock company with shares that track its units and pays distributions with stock dividends. Growth comes from the increase in shares over time and hopefully higher prices for the units when distributions are increased.

One important caveat when investing in MLPs involves their preferred tax status. The index sold off 10% from record levels in the last 2 months, partially on fears and uncertainty about this status. There is no new information but this concern will continue in an environment with an unsettled tax picture.

Assuming the custodian permits MLPs in retirement accounts, an investor may want to purchase MLPs. Excellent long term growth records make MLPs a tempting choice and venturesome investors will be willing to accept extra hassle and fees. The ultimate consideration for investing in a retirement account is selecting an investment that grows many fold over time.

Disclosure: I am long KO.