There are all sorts of tricky tax rules associated with master limited partnerships, or MLPs. One of the most important rules that MLP investors need to understand deals with the consequences of holding individual MLPs inside of a retirement account, such as a 401(k) or an IRA. Investors are usually told that they should hold dividend paying securities in their retirement accounts so that they are not taxed at ordinary income tax rates on dividends or distributions paid. Does the same hold true for MLPs, which typically pay among the highest yields of any asset class?
MLPs and Retirement Accounts
Can MLPs be held in a retirement account? Yes. Should MLPs be held in a retirement account? Probably not. Why? Because there are potentially bad tax consequences to doing so. As I'm sure you already know, the principal advantage that IRAs and 401(k)s have over traditional investment accounts is that IRAs and 401(k)s have favorable tax treatment. In the case of traditional IRAs and 401(k)s, the contributions to such accounts are tax-free and you need not pay taxes until you actually withdraw the money; in the case of Roth IRAs and Roth 401(k)s, contributions are taxed but withdrawals are tax-free.
But this tax advantage may largely disappear if your retirement account is loaded with individual MLPs. Why? IRAs and 401(k)s are subject to taxes on a special type of income called unrelated business taxable income, or "UBTI." Generally speaking, the distributions paid by MLPs are likely to be considered UBTI. If an IRA or 401(k) earns more than $1,000 of UBTI annually, the UBTI income above $1,000 is subject to tax even if the securities are held in a retirement account.
Think about the implications of this tax rule. If your retirement account earns more than $1,000 per year in UBTI, you've essentially just eliminated the tax advantage (single taxation rather than double taxation) of your retirement account! For that reason, it is usually a good idea to hold MLP common units in a taxable account rather than a retirement account.
(Side note: It is important to note that not all of the distributions paid by an MLP will be considered UBTI. This is because UBTI is calculated by subtracting the partnership's deductions allocated to the investment from the income generated by the investment. For instance, assume an investor holds $10,000 of "MLP X" in his retirement account, and MLP X pays total distributions of $1,000 annually on the investor's $10,000 investment. Also assume that the amount of income allocated to you by MLP X is 20% of the distributions you receive, meaning that you were able to defer taxes on $800, or 80%, of the distributions. MLP X has generated only $200 of UBTI, not $1,000. The deferred portion is not counted toward UBTI.)
A Better Way to Hold MLPs in Your Retirement Account
All is not lost, however! There are two primary ways that you can invest in MLPs without generating any UBTI: i-shares and ETNs/ETFs.
I-Shares
The first way to gain exposure to MLPs in your retirement account is through institutional shares known as "i-shares." I-Shares were created to allow investors to hold the securities of individual MLPs in tax-advantaged accounts, like IRAs and 401(k)s. There are currently only two i-shares available for purchase. The first, Kinder Morgan Management, LLC (NYSE: KMR) mirrors Kinder Morgan Energy Partners (NYSE: KMP). The second, Enbridge Energy Management, LLC (NYSE: EEQ), mirrors Enbridge Energy Partners (NYSE: EEP). By purchasing either of these i-shares, you get to enjoy virtually the same investment returns that you would have achieved if you owned the underlying common units.
The primary differences between holding i-shares and common units are (i) you can hold i-shares in a retirement account without incurring any UBTI or other unwanted tax consequences and (ii) distributions in i-shares are paid in stock rather than cash. Think of it like a stock split; each time a distribution is paid, you get more shares. Even better, starting one year after purchase all of your gains when you sell are treated as long-term capital gains. Another huge advantage is that you will not have to file K-1 statements as you would with traditional MLPs.
ETNs and ETFs
The second way to gain exposure to MLPs in your retirement account is through exchange-traded notes, or ETNs, and exchange-traded funds, or ETFs. Each has its benefits and its drawbacks.
The major benefit provided by ETNs is that they have "pass-through" tax treatment. In other words, there is no corporate tax payable by the ETN; just like when you own MLPs directly, the only tax that is paid on distributions is at the unitholder level. The major drawback is that ETNs are the unsecured obligation of the issuing bank, and investors in the ETNs bear the credit risk associated with that bank. For instance, one of my favorite ETNs, the JPMorgan Alerian MLP Index (NYSE: AMJ), is issued by JPMorgan. Holders of this ETN bear the credit risk (however small) associated with JPMorgan; if JPMorgan were to go into receivership (the equivalent of bankruptcy for a bank), they would be unsecured creditors and would likely lose some or all of their investment in AMJ.
The major benefit provided by ETFs is that there is no credit risk associated with the securities. There is a large price to pay for this protection, however, and it comes in the form of double taxation. MLP ETFs do not get pass-through tax treatment; rather, the ETF pays corporate taxes on the distributions it receives from the MLPs it holds and investors must also pay taxes on the dividends they receive from the ETF. Everyone must make their own investment decisions, but double taxation is, for me at least, too high a price for me to pay -- which is why I've opted for the ETN over the ETF.
Important tax disclosures
I am not a tax specialist. The information presented above was gathered from reports put out by Wells Fargo and Merrill Lynch on the tax treatment of MLPs. Therefore, I make no guarantees as to its accuracy, and you should not rely upon it when making an investment decision. This information is not intended to provide tax advice or to be used by any person to give tax advice. Taxpayers may not use this information to avoid taxes or penalties on taxes that may be imposed on such persons or taxpayers. Tax laws are complicated and subject to change. I urge you to seek tax advice based on your particular circumstances from an independent and professional tax advisor and a tax attorney.