Master limited partnerships have become a darling for investors. As high-yielding investments, they can be a great addition to an income-seeking portfolio. The Alerian MLP ETF , which is one gauge of the broader MLP industry, has a trailing-12-month dividend yield of 5.95% compared with the S&P 500 average of 2.16%.
MLPs have been around for several years, but only in recent years have they taken off in the energy space. The tricky part about MLPs is that they aren't like investing in a regular C-corporation. I've gone over some of the basics of investing in MLPs, but there are still some questions left unanswered. Today, let's look at how an MLP works in your IRA.
Pass the (taxable) buck
One of the largest reasons for a company to set up as an MLP is the preferential tax status. An MLP passes all tax obligations for the company along to the unitholders, who pay based on their personal marginal tax rate. A C-corporation, in contrast, would pay a corporate tax rate and then pay out a dividend, which is subsequently taxed as a capital gain for the individual. By passing along the tax obligation to the individual, not only does it generate more income for the individual, but it also takes money away from the IRS that would normally be collected if it was a C-corp.
And that's one of the primary reasons the government adjusted MLP laws back in the 1980s to limit them to companies that engaged in certain types of business. Before that ruling, several companies were setting up as MLPs only to avoid paying corporate taxes, so the government had to step in to ensure the continuation of tax revenues.
On the other side of the coin, we have IRAs. Traditional IRAs are taxed as the money comes out as income, and Roth IRAs contain after-tax investments. Either way, any earnings or gains that occur in the account aren't taxed at the time they're earned, giving individual investors a great method to plan for retirement without worrying about having taxes take out big chunks along the way.
The Unrelated Business Income Tax
As good as both IRAs and MLPs sound, don't expect to completely skip paying taxes if you buy MLPs in an IRA. A section of the tax code imposes what's called the Unrelated Business Income Tax, or UBIT, on IRAs with MLP income exceeding $1,000 annually.
Those who have worked with non-profit organizations may be more familiar with the UBIT. The tax code stipulates that if a non-profit entity receives income from a source not directly related to its tax-exempt function, then it's taxed on that revenue. The rule also applies to your IRA.
The IRA is considered a non-profit entity with the goal of providing individuals with a source of income when they retire through investments. Whenever you realize a gain in your IRA from more traditional methods, such as interest, dividends, or royalties, they're considered "investment income" and are thus tax-exempt. In the case of an MLP, which is itself a special type of entity, the distributions paid to the partner are considered "earned" income, and the UBIT rule therefore applies.
To report your UBIT, you or your broker will need to fill out a 990-T form to be filed on behalf of your IRA. That's on top of the scheduled K-1 form from the company that would go with your individual tax return. You may also need to pay additional tax, which you may end up paying on your own or which your broker may end up paying on your behalf -- sometimes with additional fees for the service.
What a Fool believes
There are no additional financial gains for you as an investor to have an MLP in an IRA versus any other type of investment account. If anything, it just brings in another layer of paperwork for when you go to file every year. If you have an IRA and a non-IRA investment account, you might save yourself (or your tax specialist) some headaches by keeping the MLP in the non-IRA account. That doesn't mean that you should completely avoid having an MLP in an IRA, either. This kind of business structure can provide strong yields for long-term-minded investors and could help you in securing financial flexibility during retirement.
Making the right financial decisions today makes a world of difference in your golden years, but with most people chronically undersaving for retirement it's clear not enough is being done. Don't make the same mistakes as the masses. Learn about The Shocking Can't-Miss Truth About Your Retirement. It won't cost you a thing, but don't wait, because your free report won't be available forever.
The article An Investor's Guide to Master Limited Partnerships: MLPs and IRAs originally appeared on Fool.com.
Fool contributor Tyler Crowe has no position in any stocks mentioned. You can follow him at Fool.com under the handle TMFDirtyBird, at Google +, or on Twitter: @TylerCroweFool.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.