Investors often ask if they can invest in MLPs through their retirement accounts – IRAs, 401(k)s, and similar plans which are allowed to earn tax-deferred income under the Internal Revenue Code. The regular cash distributions offered by MLPs make them an appealing possibility for investors wishing to build up retirement funds.
You Can, But…
The answer is yes, IRAs, 401(k)s, and other qualified retirement accounts are allowed to invest in MLPs the same as any other traded security. There is nothing in the federal tax code or pension laws that says they cannot. Before you add MLPs to your retirement account, however, there are some special considerations that you need to weigh carefully and discuss with a professional tax advisor.
First, remember that one reason many people buy MLPs is for the tax advantages — the tax-deferred distribution and the ability to offset taxable income passed through from the MLP with depreciation and other deductions. In a retirement account, however, the income is already tax-deferred, so the tax benefits of an MLP are, in a sense, “wasted.”
More importantly, contrary as it may seem, holding MLPs in a retirement account can result in the account owing tax.
Unrelated Business Income Tax
There is a concept in the tax code (I.R.C. §§511-514) called “unrelated business income tax” (UBIT). Under the UBIT rules, tax-exempt organizations and retirement accounts must pay tax on their “unrelated business taxable income” (UBTI) – income from a business that is not related to their exempt purpose (a university operating a business that had nothing to do with education would be an example).
If your IRA invests in an MLP, it becomes a limited partner in that MLP, just as you would if you invested directly. Because an MLP, like all partnerships, is a pass-through entity (no tax paid by the partnership, all tax items flow through to the limited partners/shareholders, who pay tax on their share), the partners are treated by the tax code as if they are directly earning the MLP’s income. Thus, as a partner in the MLP, the IRA or other account is considered to be “earning” its share of the MLP’s business income. The MLP’s business is not related to the retirement account’s tax-exempt purpose; therefore the IRA’s share of the MLP’s income is treated as UBTI and is taxed accordingly.
The tax is owed on the retirement account’s share of the MLP’s taxable business income, minus its share of depreciation and other deductions related to the business, as reported on the K-1 form (not on the quarterly distributions). The K-1 contains a line reporting how much UBTI the MLP is passing through. The tax rate is the highest tax rate for a trust, currently 39.6%. There is a deduction that covers the first $1,000 of UBTI from all sources; after that, the retirement account will owe tax.
It is important to remember that you are not the one who will owe any unrelated business income tax on MLP units held in your retirement account. The tax is owed by the IRA or other retirement account itself, as it is the partner in the MLP. It is the responsibility of the custodian of the account to file a tax return (form 990-T) and pay any tax owed out of the account’s funds.
Should I Hold MLPs in my Retirement Account?
Investment advisors who follow MLPs differ on whether it is a good idea to include them in a retirement account:
Some analysts feel it’s inappropriate to put an MLP in a retirement account. They argue that because the tax benefits are such an important feature of MLPs, this investment should be in a taxable account where the benefits can be realized. They also feel that placing MLP investments in an account where they are subject to UBIT unnecessarily diminishes the return and creates additional complexity.
Others argue that because MLPs’ income is slargely offset by deductions like depreciation, taxable income for many retirement accounts may well be below the $1,000 UBIT deduction. They also feel that the income aspect of the MLP is the most important benefit, and that even if the retirement account does have to pay tax, the cash distributions will still provide a highly desirable return on an after-tax basis.
This is a decision that investors need to make for themselves after weighing their priorities, consulting their tax and investment advisors, and running the numbers on the MLPs that interest them.
Other Alternatives for Retirement Accounts
If the prospect of incurring UBIT makes you shy away from a direct investment in MLPs for your retirement account, there are alternatives that will still provide many of the rewards of MLP investment without the adverse tax consequences. There are currently several mutual funds, both closed-end and open-end, which invest in MLPs and pass their MLP income through to their investors as dividends. In addition, it is possible to invest in some MLPs through publicly traded affiliates taxed as corporations. If you want this income opportunity for your retirement account but don’t to risk incurring UBIT, you may want to consider these options.
- IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations (partnerships are discussed on page 13).
- Internal Revenue Code §§511-514, Unrelated Business Income Tax (rule for partnerships is in section 512(c)).
The information on this page is for informational purposes only and should not be construed as offering tax or investment advice. Consult the appropriate advisor regarding your own situation.