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Should you hold MLPs in IRAs or 401(k)s? 49 comments
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.
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This post has 49 comments:
Any thoughts as to the conclusions of Ron Rowland?
Obviously, the decision on whether to hold MLPs in a retirement account depends on the investor's perception of the tax risk associated with doing so. I don't proclaim that one approach is definitely "right" and the other is "wrong;" rather, I am trying to shed some light on the risks associated with one of the two approaches.
I have a question if you don't mind:
I know that the IRA custodian is responsible for filing form 990T for UBTI and paying any tax out of the IRA monies, but how is the tax paid for the sale of an MLP from an IRA account? Or is that deferred til withdrawal from the IRA like any other profits made in the IRA?
Moreover, the blogger stated, "Generally speaking, the distributions paid by MLPs are likely to be considered UBTI." Holy cow! That's news to me! If the distributions emanate from cash flow generated by the company's primary energy-related business, how is that Unrelated Business Taxable Income? I think that "are likely" should read "are unlikely."
Finally, it's a great relief to compound high income in an IRA without the labyrinthian complexities of K-1's.
Regarding iShares, you state: "Even better, starting one year after purchase all of your gains when you sell are treated as long-term capital gains."
If the account in question is an IRA, 401(k) or equivalent, I understand that all withdrawals are treated as ordinary income, since the money had not been taxed previously. If the account in question is a Roth account, none of the withdrawals is taxed at all, the original earned income having already been taxed, correct?
So, how does a withdrawal from either get favorable tax treatment as a long term gain?
Thanks,
Mike
Question: Are the tax regs (and the implications for IRAs) for REITs similar to those for MLPs?
The following two links relate directly to this article:
http://bit.ly/yb1qPX
http://bit.ly/Hlq1xS
He maintains, that , when selling a MLP in an IRA that it is a complete tax event[recapture] and ordinary income is UBTI subject to 35% tax.
Do not rely on my brief statement, Read Reel Ken!
I'm contemplating moving my IRA MLPS to my taxable acct, by way of my yearly RMD. I believ the prices will reset.
Not knowing your qualifications, you could be suspect!
thanks
Everyone must make his/her own investment decision...
Anyone here speak English?
The basis of an MLP is cost less the operating losses during the period of ownership. This means that you could have a taxable gain for tax purposes even if you sell if for less than you paid for it and that is the real exposure for most people.
Again based on my reading, the amount that is taxable in an IRA will be calculated as follows: operating gains less operating losses for the year plus the gain on the sale to the extent that it results from a reduction of basis as a result of losses taken in prior years.
This is something that CPA's don't seem to understand and it is very difficult to research. My MLPs are owned in my personal account. I cannot even figure out how to pay the tax in the IRA if I had any. Schwab will will calculate the tax for you if you use Schwab.
PS. Try finding an person who professes a high level of technical knowledge on this point. I have not found a single "how to" article by a tax attorney or CPA that addressed these issues with any clarity. I tried to do the return to pay the tax and I could not even begin to complete it (and I am a former CPA.) As i said, I do not own my MLP's in my IRA because I do not need the hassle (and the exposure to a double tax.)
After some consideration,and various opinions, I decided to transfer some mlps to my trust by way of my yearly Required Minimum Distribution[RMD]. I'm told that, by to paying ordinary income on the transfer, that the the basis and cost will reset , and is not a sale. Won't know for sure, until I get my 2012 K-1's Happy to avoid the IRA issues.
A number of folks have posted that you should report negative UBTI via form 990-T because you can use it to offset positive UBTI in subsequent years. I have seen such posts from folks who I am inclined to believe, but I have not independently confirmed this.
A number of brokerages will do the reporting, calculation and pay the tax for you on over the limit UBTI from your account (Schwab?, Vanguard, and others) and some will not (Fidelity when I last checked). If your brokerage will handle this, you still need to make sure that they have received the K-1s for all of your MLPs held in your retirement account (some K-1's may only be sent to you).
Ledlights--what is your source of information on this?
My understanding is that the $1000 is the annual allowed UBTI deduction for an IRA (or any tax exempt entity) so it only makes sense to me that it is cumulative. There are other things that can contribute UBTI to an IRA besides MLPs.
from
http://bit.ly/Hlq1xS
"There is a deduction that covers the first $1,000 of UBTI from all sources"
or from here:
IRS pub - http://1.usa.gov/Qigwqj
"Form 990-T is required if the organization’s gross income from unrelated businesses is $1,000 or more"
My understanding is that any "tax exempt entity" such as an IRA can be substituted here for "organization"
Hmmm... Is the deduction for $999.99 or $1000.00?
Anyone, correct me if I am wrong, but the 990-T is being filed for the IRA, it is not being filed for each individual source of UBTI in an IRA.
I am holding NLY REIT in my IRA, and am told that I need to do UBIT work. Someone above said "no" ( jdh44) but April May seems to indicated YES. I have never received a K-1 from any reit, unlike the MLP. I also searched the IRS document and find no mention of REIT whatsoever.
Comments or know how ?
Much appreciated if you can clarify.
REITs: 1) Are not subject to UBIT. 2) Pay dividends to shareholders. 3) Send you a 1099. 4) You pay tax at ordinary rates like you would for a money market fund, for which you also receive a 1099. 5) Are ideal investments to hold in an IRA, and best yet a Roth IRA.
MLPs: 1) Are subject to UBIT but only if the partnership engages in an unrelated business activity, i.e. a pipeline MLP operating a grocery store. 2) Pay distributions to their unit holders. 3) An LLC is also a pass-through entity, like an MLP without a general partner. 4) Send you a K-1. 5) You pay tax according to the amount of income your partnership interest earns, which has little if any relation to the cash amount of the distribution you receive. 5) Typical partnership distributions are some combination of return of capital and depreciation, varies by partnership. 6) Are best not held in an IRA.
Others have suggested that if you want to do frequent trading in MLPs then keeping them in tax free accounts has distinct advantages - which I assume has to do primarily with the multiplying complications of handling the taxes when you trade MLPs in a taxable account.
One of the better discussions follows this article:
http://seekingalpha.co...
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