I have MLPs in IRAs that I manage for my family. There is some controversy about this practice, and I have done a considerable amount of research about it. It was no surprise that the best information came from Seeking Alpha; particularly from ReelKen, John D. Thomson, and the excellent commentary from elliot_mllr. After reviewing all this guidance, I still had questions in my mind and I will try to answer them here.
If you are not familiar with the basics of MLP investing you may want to read the primer on MLPs that I wrote a few weeks ago. This article assumes that you are familiar with those basics.
Many authors warn against putting MLPs in IRAs. They are aware that special rules are involved with IRAs holding MLPs. Rather than take the time to research and explain what is going on, it is simpler to point out that rules are there and that "you should consult your tax advisor".
I fear that these warnings are keeping investors from making great IRA investments. I think it's important to examine the issues so that you can decide for yourself whether MLPs make sense for your IRA. Let's look at them individually:
MLPs are tax advantaged instruments. Common wisdom is that tax advantaged instruments do not belong in an IRA.
There is no question that this statement is true in general. Normally, tax advantaged instruments pay less than similar investments that are not tax advantaged. The best example of this is municipal bonds. Municipal bonds pay lower interest rates than other bonds of similar risk because the interest paid by municipal bonds is tax exempt.
In addition, by placing MLPs in an IRA you give up their special tax advantage. All income received by the IRA is tax deferred, so to ability to defer income from MLP distributions doesn't get you anything further.
Thus, if you have a choice you are always better putting your MLPs in a taxable account than in an IRA.
That said, many investors (including me) have put all or almost all of our investments in IRAs. When looking over currently available investments, MLPs often are superior to anything else.
IRAs need require special accounting for MLP investments. Keeping MLPs out of IRAs avoids these problems.
This is true, but it probably shouldn't keep you from putting MLPs in your IRA (assuming you don't have a taxable account to house them).
Normally, the broker does this work for you and files a form 990-T for your IRA. If there is additional tax due the broker pays the tax out of the IRA.
I have seen sources indicate that some brokers won't file the 990-T themselves, or that they will charge $200 for the service. That may be true, but I know that my broker (Schwab) is happy to do the 990-Ts for me free of charge. It's likely that your broker will also do this for you free of charge.
Most importantly, if an IRA has MLP investments then the IRA may have to pay a yearly tax on the unrelated business taxable income (UBTI) of the MLP. Authors often mention that a tax may have to be paid with the implication that other investments should be used to avoid paying the tax.
A deeper look should be taken because there is rarely tax due. The tax is based on the UBTI shown on line 20V of the K-1 the MLP sends out each year. For many MLPs this amount is negative. Where a positive amount is shown it is combined with the negative amounts for other MLPs owned in the same IRA. The first $1,000 of the combined UBTI is tax exempt. If combined UBTI is greater than $1,000 then the IRA must pay a tax. The tax amount is:
$50,000 or less
15% of UBTI*
$50,000 - $75,000
$75,000 + 25% of the UBTI* over $50,000
$75,000 - $100,000
$13,750 + 34% of the UBTI* over $75,000
$100,000 - $335,000
$22,250 + 39% of the UBTI* over $100,000
*UBTI greater than $1,000
The UBTI tax is based on the IRA UBTI income only. It is not based on your tax rate. You may have taxable income of $1,000,000, but if the combined UBTI from the MLPs in your IRA is $10,000, then the IRA's tax will be $1,500 (15% of $10,000).
The tax is paid by the IRA, not you.
Since the MLPs with negative UBTI offset the MLPs with positive UBTI is very hard to get even +$1,000 of UBTI. Getting combined UBTI of more than $50,000 (where the tax rate increases past 15%) is almost impossible.
Many MLPs pay distributions of more than 8%, including four of mine (Breitburn Energy (BBEP), Mid-Con Energy (MCEP), QE Energy (QRE), and Vanguard Natural Resources (VNR)). Even if UBTI tax is due the income earned will still be considerable. For example, an 8% distribution will still yield the IRA 6.8% after UBTI tax; a 10% distribution will yield 8.5% after UBTI tax. In fact, the yields will be much closer to 8% or 10% because of the limits and combinations described above.
Finally, there is some thought that considerable UBTI and tax may be generated when all the units of a particular MLP are sold out of an IRA. I say may because of I have sold out of MLPs in an IRA before and I have never noticed the increase in UBTI or tax. I sold out of both Kinder Morgan Partners (KMP) and Energy Transfer Partners (ETP) in one year and there was no UBTI tax paid. I haven't studied the issue hard enough to know whether a mistake was made, the amounts were small enough to keep away from UBTI tax, or both. The only thing I'm sure of is that UBTI tax has not been a problem for me so far.
I also called my broker and they told me they only consider the amount on line 20V when they put together the 990-T. Thus, any adjustments made for the final year that an MLP is owned must be made by the MLP itself, and the adjustments must be reflected in line 20V for my IRA tax to be affected. It is possible that KMP and ETP made these adjustments last year and they were simply not enough to override the negative amounts from other MLPs. Therefore, it may be possible to significantly reduce the hit from exiting an MLP in an IRA just by having other MLPs in the same IRA that will produce significant negative UBTI.
It may well be that if I hold enough units long enough I will see a large UBTI one year that will generate a nasty tax. I will be watching my K-1's accordingly. I even plan to sell out of my remaining units in Linn Energy (LINE) in one small IRA I manage just to see what happens. If I do this, I will probably buy the same amount of units in another account because tax decisions should not override investment decisions.
If I carry out this plan, I will report back what I find, either in another article or in my instablog. In the meantime, I will continue to invest in MLPs for my IRAs and I will continue to assume there will be no UBTI tax. This assumption has worked until now, and I'll continue to make it until I see evidence that UBTI tax matters to me.
Disclosure: I am long BBEP, LINE, MCEP, QRE, VNR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
I have trading for my own and my family's retirement and investment accounts since the mid 90's. I've ridden up the 90's and survived enough thru the past decade+ that I can still stend mu full time investing. Currently, I've got about 50% of my investments in preferred stocks 20% in MLPs and most of the rest in tech, consumer discretionary and staples.