MLPs: Good For Retirement, But Not Retirement Accounts?

Article by Investment U

MLPs: Good For Retirement, But Not Retirement Accounts?

If you want to use master limited partnerships for your retirement, just hold them in a brokerage account and take advantage of the tax breaks and high yields.

I’m tired of writing about it, and I’m sure you’re getting tired of reading about it…

Treasury yields are awful. Europe is awful. It seems I’ve been leading off with the same premise for the last year. So it’s a given that my goal is to help you find something that’s not going to be awful because of European uncertainty with a yield that beats inflation.

Ladies and gentlemen, I present to you, master limited partnerships (MLPs).

What Can MLPs Do for Me?

We’ve spilled a bunch of ink over the past few months about MLPs, but just in case you’re not completely familiar with these vehicles, here’s a quick run-down:

MLPs combine the tax benefits of a limited partnership with the liquidity of common stock. They have a partnership structure but issue investment units that you can trade just like common stock.

What we now know as MLPs were created by the Tax Reform Act of 1986 and the Revenue Act of 1987. These two pieces of legislation gave the guidelines of how a company can structure their operations to get specific tax benefits along with defining eligibility. To qualify, a firm must earn 90% of its income through activities or interest and dividend payments relating to natural resources, commodities or real estate.

That’s the “proper” definition, but here’s why they are growing popularity:

  • Many investors consider MLPs to be generally low-risk businesses because a high portion of their revenues are expected to come from long-term, fee-based contracts with built-in price escalators.
  • Unlike bonds and their fixed yield, a MLP is designed to give you a growing income stream over time, which can serve as a hedge against interest rate risk and inflation.
  • The publicly traded MLP sector is over $350 billion in market cap today and has been one of the best performing asset classes for the last 10 years.
  • There is some diversity out there. MLPs are not all the same and there are many different sub-sectors within the asset class.
  • Some investors view MLPs as total-return vehicles rather than income plays as there has been approximately a 7% cumulative growth rate in MLP distributions over the past 10 year period.

Capitalize on a Bright Future

Many analysts in the energy industry believe that MLPs will be the primary entities to handle the massive build-out of energy infrastructure across the United States over the next few decades.

This country has a lot of natural gas that’s been discovered over the past decade and lately we’ve discovered more crude oil. This could be the start of something big in the future. Here are two additional points to keep in mind:

  1. Last year the United States became a net exporter of petroleum products for the first time in over six decades.
  2. The Interstate Natural Gas Association of America estimates the need for over $250 billion in energy infrastructure to be built by 2035 in order to transport all of the newly found domestic oil and natural gas.

Good For Retirement, But Not for Retirement Accounts?

I think you need to understand an MLP’s tax structure to see why they’re perfect for retirement.

The tax implications for MLPs are totally different than corporations for both the company and its investors. MLPs don’t pay corporate taxes. Instead, taxes are considered “pass through,” meaning liabilities and expenses are passed through to the investors. MLP investors may write off partnership expenses, depreciation, and other things against income on their tax returns.

However, the tax benefits you get in a MLP can work against you if it’s put in a retirement vehicle like a 401(k) or IRA because you’ll miss out on some great tax breaks. And there’s a possibility that you could get hit with additional taxes you weren’t expecting.

MLPs in a retirement vehicle fall under the tax rule of Unrelated Business Taxable Income (UBTI). You pay this when cash distributions from an investment are considered unrelated to the structure that gives an entity its tax-exempt status. In other words, income from oil and gas is unrelated to saving for retirement, so Uncle Sam wants his cut. This primarily comes up when an investor has a big position in a MLP. But it could affect the average investor who has a particularly successful hit.

Some analysts believe that UBTI is no big deal in a retirement account because it’s actually the custodian’s responsibility to file these taxes, not the individual’s.

“Technically, that’s true, says Mary Lyman, executive director of the National Association of Publicly Traded Partnerships. “But what we hear from investors is that many times their custodians don’t really have a clue what to do.”

And, even if they do, it’s likely they’ll charge a fee for these services, says Mark Willoughby, principal at Boston-based Modera Wealth Management.

How to Invest in MLPs for Your Retirement

If your heart is set on having an MLP in your retirement account – even after reading my eloquent argument to not do so – then you can invest in exchange-traded funds and open and closed mutual funds that focus on MLPs. The shareholders in these accounts are not subject to UBTI taxes so that’s not what you have to worry about.

The real monster is the fees you most likely will have to pay. Fund companies are not considered “pass through” entities, they pay corporate taxes on MLP earnings. And since they pay, you’ll pay pretty high fees. Plus, total returns are often lower than you might get from individual MLPs.

It’s probably best that if you want to use master limited partnerships for your retirement, just hold them in a brokerage account and take full advantage of the tax breaks and high yields.

Good Investing,

Jason Jenkins

Article by Investment U