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This article covers the pros, cons, and key issues to consider in making MLPs part of your retirement (and thus to some degree, estate) planning.

Actually, given how MLPs have outperformed other income equities in yield and appreciation over the past decade (see below for details), the question isn’t whether or not MLPs make sense for most income investors, they probably do. For those focused on building saving and an income stream for their retirement, the only question is whether or not these tax advantaged income sources should be held in a retirement account.

The role of MLPs in retirement accounts has become a hot topic in recent years as investors desperately seek strong risk adjusted returns.

MLPs In Retirement Accounts: Pros And Cons

Most investors want their retirement investments in some kind of retirement account because of the tax savings these provide. There are pros and cons to holding MLPs in these kinds of accounts, and your final decision about doing so will depend on how your personal situation and priorities mesh with these.

Cons: Reasons Not To Hold MLP Units In Retirement Accounts

  • MLP Tax Deferral Advantage Wasted In IRA Or Other Tax Advantaged Account

  • In a retirement account the income is already tax deferred. That means you not only:

    • Get no added benefit from the tax deferred income advantage of MLP distributions,
    • you also still may suffer the unique MLP tax disadvantages if you sell (depending on individual particulars
      • reduction in cost basis and thus possibly a higher future capital gains tax if you sell during your lifetime
      • recapture of all deferred income as a return of capital at higher, ordinary income rates, rather than having it taxed at the lower long term capital gains rate that you’d pay when selling an ordinary stock
  • IRAs, UBITs, And UBTIs: May Incur UBTI If Held In Retirement Or Tax Exempt Account
  • In order to prevent for-profit enterprises from avoiding tax by operating within tax exempt entities, the IRS requires that otherwise tax exempt entities pay “unrelated business income tax,” (UBIT). Per these UBIT rules, tax exempt organizations and retirement accounts pay tax on their “unrelated business taxable income” (UBTI), which is income not related to their tax exempt purpose, if it exceeds $1000. Unlike dividends, MLP distributions are treated as a share of MLP business income.

    In addition to the risk of owing tax on an otherwise tax deferred account, the UBTI must be reported via a form 990-T and paid out of the account’s funds by the custodian, who may charge a service fee high enough to reduce the appeal of holding the MLP in an IRA.

    Finally, remember that as with any asset held in a retirement account, your access to it may be limited or penalized. The point is so obvious that it can be forgotten. So if, upon running your own numbers and weighing your priorities, you find the advantages and disadvantages roughly balanced, remember to consider the liquidity advantage of keeping MLPs outside of your retirement accounts, especially because MLPs are already tax advantaged investments.

Pros: Reasons To Hold MLP Units In Retirement Accounts

  • MLP Returns May Be High Enough To Outweigh The Above Disadvantages

  • The common belief is that tax advantaged investments don’t belong in a retirement account. As a general rule this makes sense because most tax exempt or deferred investments offer lower yields than comparable taxed investments. They are still in demand despite that low pre-tax yield because their after tax yield is higher than similar taxable investments for those who would otherwise be subject to tax on that income. A classic example would be municipal bonds, which yield less than corporate bonds with the same perceived risk, however the tax exemption gives these bonds a greater after tax return for those in higher tax brackets.

    However that reasoning usually doesn’t apply to MLPs. MLPs are not only relatively high yielders; they have handily outperformed the other popular income equity investments from the start of 2003 to the end of 2012.

    Note in the table below, the sixth line down labeled Dividend Yields. AMZ is the benchmark MLP index.

    Annualized Returns: Alerian MLP index (AMZ) vs. Other Popular Income Paying Equity Investment Indexes

    Source: www.alerian.com [i]

    06 apr 23 2301

    Even if we just focus on MLPs’ dividend yield advantage, at first glance it appears that on average this alone justifies considering MLPs for an IRA. Depending on the kind of IRA you have, the income may still be tax deferred anyway. So as long as you don’t incur enough UBIT or added accounting fees to eliminate the income advantage, your bottom line may still be better with MLPs.

    Obviously you’d have to consider more than just the yield advantage. Each investor would need to weigh such factors as:

    • The prospects of the specific MLP you’re considering: Both in terms of yield and unit price growth, versus those of other potential investments. For example, the growth in the energy sector from new extraction technologies and prospects for long term energy demand may cause one to be particularly bullish on the chances for growth in both income and unit prices of certain MLPs.
    • Diversification issues: MLPs are strictly limited to certain kinds of operations, with many of the safest yields coming from those in the midstream (gathering, transporting, and processing) energy sector. If one already has as much weighting in this sector as they want, they’d have to choose what investments to keep, add, or sell off to avoid being overweight in the MLPs’ sectors.
    • Other MLP specific risks, which we cover in depth in Part Six.

    In sum, the bottom line for whether to hold MLPs in your retirement account is, well, the bottom line. If it still provides the best after tax yield of your available alternatives, who cares if you wasted a tax deferral that you get anyway?

  • Usually, UBIT Is Avoidable

  • UBIT Unlikely Unless Have Large Positions: MLP taxable income is largely offset by deductions like depreciation. When you examine your K-1, you’ll find that UBTI tends to correlate closely with taxable net income. As we’ve mentioned earlier, that tends to be about 20% or less of your total distribution. Therefore unless you hold over $100k in MLPs in a given IRA account, you’re unlikely to incur UBTI.

    For example, if you bought $100k of an MLP with a 5% yield, you’re getting $5000 in distributions per year. Assuming 20% of that, $1000, is taxable income and that UBTI is less than or equal to taxable income, then you don’t exceed the UBTI exemption.

    You Can Avoid It With Multiple IRAs: Also, the $1000 exemption on UBTI is on a per account basis, not a per taxpayer basis. That means in order to cut your risk of incurring any UBIT, you can simply have your MLPs distributed among multiple IRAs, assuming their yields justify any additional from having multiple retirement accounts.

    UBTI Can Be Offset By Prior Year Losses From The Same MLP: Prior year net losses from a given MLP can be used to offset future taxable income (and thus UBTI), but only from that same MLP. In other words, losses from one MLP cannot offset losses from another.[ii]

  • A Little UBTI May Be Acceptable

  • Finally, UBTI rates on the first $2300 of UBTI are only 15%, and rise as per the below table. That’s the same rate or lower than most investors would pay on their long term capital gains or qualified dividend income. Here’s a table showing UBTI rates on amounts above the $1000 exempt portion of UBTI.

    Note: Because an IRA is considered a trust, a self-directed IRA subject to UBTI is taxed at the following trust tax rates:

    • $0 - $2,300 = 15%
    • $2,300 - $5,350 = $345 + 25%
    • $5,350 - $8,200 = $1,107.50 + 28%
    • $8200 - $11,200 = $1,905.50 + 33%
    • Over $11,200 = $2,895.50 + 35%

    So how large a position in MLPs could you have while staying within this low 15% rate?

    Just to give you a rough idea, and to keep the math easy, we’ll continue with the above example and assume:

    • A 5% gross yield on every $100,000 of MLP units, $5000
    • A typical 20% of that yield is taxable net income, which happens to equal UBTI, $1000

    That suggests that you could have up to about $300,000 of MLPs in each IRA you have. The first $100,000 produces $1000 of UBTI, which is exempt, and the next $200,000 produces about another $2000 of UBTI, so you stay under the $2300 limit for UBTI that is taxed at 15%.

    How much does that 15% UBIT tax reduce your 5% yield? Not by much. For example:

    Total MLP Income $300,000 @ 5% $15,000
    Taxable UBTI (assumed 20% of the distribution)
    minus the first $1000 of UBTI that is tax exempt
    20% of $15000 = $3,000
    Less $1000 (1,000)
    Taxable UBTI $2,000
    UBTI Tax 2,000 x 15% (300)
    MLP Income Net of UBIT 15,000 - 300 $14,700
    =====
    MLP Yield Net of UBIT 14,700/300,000 =0.049 4.9%

    That yield still crushes average decade yields on REITS, Utilities, DJIA and S&P 500 stocks.

    The point here is simple, don’t make too much of UBTI.

    As long as MLPs continue to easily outperform the other common forms of income equities and investment grade bonds, UBTI concerns by themselves probably shouldn’t dissuade you from holding MLPs in your retirement account, even after consideration of any additional fees related fees from UBTI reporting or from having multiple IRAs.

Conclusion?

From a pure yield perspective, the above suggests that holding MLPs in your portfolio probably makes sense unless you’ve got alternatives that offer a better income/growth combination.

Obviously the decision of whether to keep MLPs in your retirement or in a taxable account would require weighing your personal circumstances and priorities. For example:

  1. There are a great many possible variables that could influence your decision. For example, your willingness to accept the extra tax reporting work or accounting fees.
  2. Higher net worth investors who would hold larger MLP positions may need to consider UBIT costs (and whether it pays to hold MLPs in or outside of their tax advantaged accounts), whereas those with smaller accounts may not. However if there are any related administration fees, as long as MLPs continue to hold such a substantial performance advantage over competing income investments, UBIT does not appear to present a decisive obstacle to holding MLPs in a retirement account. Also, if UBIT becomes a material consideration, it can be circumvented by using multiple retirement accounts.
  3. MLPs are mostly in the natural resources sector, mostly in energy. Like any other sector, this too will at times be so oversold or in such a strong uptrend the capital appreciation potential and yield outweigh the likely tax consequences under these circumstances.
  4. MLPs’ concentration in a limited number of activities means one must consider the risks of being overweight these sectors if you load up on MLPs.
  5. As discussed in part 2, distributions in excess of income reduce cost basis, so if an MLP is held for the long term cost basis can be reduced to zero, and one would need to consult a professional about the related tax ramifications.
  6. For investors who do their own tax returns, the added tax reporting burdens may outweigh the benefits of the added income and capital gains potential.
  7. Much also depends on your personal assessment of the prospects for MLPs in general, their specific sectors, and for specific MLPs. It’s possible that significant changes in tax treatment, interest rates, or energy demand could radically alter MLPs appeal for better or worse. Some see MLPs’ decade long run as a sign of being overvalued and due for a pullback. Others look at growth in demand for both energy and especially energy infrastructure, given the vast new energy producing regions coming on line due to new extraction technologies like fracking and horizontal drilling.

Meanwhile, MLPs’ outperformance of every other popular income investment class in both yield and price appreciation makes them far too compelling to ignore. The only question is which form of exposure and account works best for you.

Alternatives To Direct MLP Ownership For Retirement Accounts

There are many who, for a number of possible reasons, are uncomfortable with holding individual MLPs in general, or at least in their retirement account. To meet the needs of those seeking MLP exposure without the bother of choosing them or dealing with their tax and tax reporting issues, a variety of alternatives are available to direct MLP ownership.

In Part Five on alternative ways to invest in MLPs, we’ll look at the pros and cons of these alternatives in greater detail. Here’s a brief look at these MLP products, with an emphasis on their suitability for retirement accounts.

The key point to know is that none are a panacea, and all involve some kind of imperfect tradeoff, typically you sacrifice return for convenience.

Advantages: All of them will be easier to hold in a retirement account than the actual MLP units, as all avoid most of the tax reporting and payment issues, including UBIT. Funds offer better diversification via the variety of MLPs they hold (especially for small accounts that can’t afford to own about 10 different MLPs), possibly better liquidity, and greater simplicity. Management takes care of the tax and MLP selection hassles. In some cases, share price might exceed MLP unit price, particularly in the few cases in which the MLPs created their own publicly traded corporate versions of themselves. These typically are just corporations that own nothing but units of the MLP, and issue dividends based on their distributions, after they pay corporate tax on this income, withhold for future capital gains, etc. Reporting is as simple as any dividend income, they issue DIV 1099 forms.

Disadvantages May Include: Lower overall returns, due to a combination of factors that will vary with each product. These include:

  • Double taxation at both fund and shareholder level, and other taxation disadvantages inherent in the structure of these products, such as possible loss of some or all tax deferrals in some cases but not others.
  • Management fees
  • Need to set aside cash at the fund level for future capital gains and other taxes owed due to the corporate nature of most of these products
  • Risks unique to the specific MLP product: For example, some funds use leverage. ETNs are unsecured debt instruments, so they have credit risk. In other words, they could lose value if their issuer’s credit rating drops, or be wiped out if the issuer becomes insolvent. The risk is usually small, but real.
  • The most popular MLP products are:
  • Funds:
    • Closed end mutual funds
    • Open end mutual funds
    • Exchange traded funds (ETFs)
  • Exchange Traded Notes (ETNs): These are not funds but debt instruments with a bond like coupon payment linked to a given MLP index. They offer some compelling advantages over ETFs, such as lower fees, pass through advantages (no tax at the ETN level), and better tracking of their benchmark index. However some of these may not be relevant for retirement accounts. Again, however, because they are unsecured debt notes, they carry credit risk, so their prices can vary with the credit rating of the issuer.
  • MLP Organized Corporate Holding Companies: A few MLPs have set up their own corporations, whose sole asset is their units of the MLP or, in one case, Kinder Morgan Inc., (KMI), shares in the General Partner.

How To Choose The Best One For Your Retirement Account

As we’ll see in Part 5 on alternative ways to invest in MLPs, choosing which alternative is best is mostly a question of deciding:

Which produces the best return without considering tax deferral advantages, because retirement accounts provide those anyway.

Much of that decision will hinge on your own personal predictions regarding a variety of factors. For example:

  • Your planned holding period. As we discuss in Part Six, those planning on holding MLPs for over 10 – 20 years or more and then selling them, may have a significant “balloon-like” tax payment that may or may not be influenced by the type of retirement account you have. In contrast, that payment is avoided if units are held until death and they’re transferred to your estate and heirs.
  • Your views about the future prospects of MLPs in general, and whether they will continue to outperform other income investments enough to justify the added tax reporting and payment complications, either in or outside a retirement account.
  • If you’re considering one of the MLP’s own ‘in house’ holding corporations, the prospects for that specific MLP.
  • If you’re considering ETNs, whether or not you’re comfortable with the credit risk. For example JP Morgan is the issuer of one of the most popular ETNs, and as of this writing its credit rating is good. However like many large “too-big-to-fail” banks it does have significant derivatives exposure that in theory could create problems if its hedging strategies or those counterparties providing the hedges, ahem, fail to perform as planned.

This is more than a theoretical possibility. In September of 2008, just after having supposedly established a hard line against bailouts with Lehman Brothers, the US did an about-face and loaned insurance giant AIG $85 billion. Why? Because it was the insurer for an estimated $180 billion of default insurance instruments called credit default swaps.[iii] If an institutions hedged bets are no longer hedged, that could radically change the credit rating of the institution. The fear was that there would be a run on all financial institutions that might have hedged their trades or bond purchases with AIG, which included enough big banks to cause a financial collapse. The point is that credit risk is real, and in times of trouble, when you most need the hedges, they’re most prone to fail. Ask the folks from Lehman or AIG.

Til Death Do US Part: MLPs In Estates

Assets held for retirement income are likely to wind up in one’s estate, so it’s worth knowing a bit about how MLPs are treated.

The key points to know about MLPs in estates include:

MLPs held for 10-20 years may have low or zero cost basis because most of their distributions, about 80%, exceed net income and are deemed a return of capital that is deducted from the cost basis. As noted in Part 2, if the MLP is sold during the investor’s lifetime, the cumulative distributions that were not taxed at ordinary rates are “recaptured” by being taxed as ordinary income. It can result in an unexpectedly large tax bill in the year of sale

However, MLP units held at the time of death may well escape some or all of that recapture.

Upon transfer to heirs, that cost basis is stepped back up to current value. There is some controversy, however, about whether the units merely transfer at the stepped up basis, or whether they can then be sold at that stepped up basis (less any return of capital from distributions received by the heirs), that would bring much taxable lower capital gains.

However that doesn’t mean there is necessarily any tax savings.

Estate tax is levied at the stepped up basis, so the estate may be reduced by estate tax on the full stepped up basis. Depending on individual circumstances, the size of the estate, the type of heirs, and other details of prevailing estate tax law, that estate tax rate may be higher or lower than the ordinary income tax rates applied to recapture. For example, if the estate is under the amount exempt from estate tax, then there is no estate tax and the units may escape all recapture from both income and estate tax. Similarly, assets left to a spouse or recognized charity, are typically exempt from estate tax.


[i] http://www.alerian.com/wp-content/uploads/AMZfacts.pdf

[ii] http://seekingalpha.com/article/882601-don-t-be-afraid-to-put-mlps-in-your-ira, see comment by Philip Trinder, in which he writes:

I was at an MLP Conference here in Houston last Monday and they had a panel of experts that was asked the UBTI in IRA questions specifically about using one MLP's net loss to offset the net income from a different MLP in an IRA. The panel of experts all clearly said that under the tax code … that if an MLP generates a passive income loss that loss is a "suspended loss" to only be used in relation to future possible income or gains from that same exact MLP … And that each MLP needs to be tracked and treated as its own "silo."

[iii] http://www.time.com/time/business/article/0,8599,1841699,00.html “RBC Capital Markets analyst Hank Calenti estimated Tuesday that AIG's failure would cost its swap counterparties $180 billion.”

Read more: http://www.time.com/time/business/article/0,8599,1841699,00.html#ixzz2SilEPUrV