MLPs: Your Best Buy for Dividends?

If you need income from your investment portfolio, you're not alone. Millions of investors have struggled in recent years to find income-producing assets in an environment in which ordinary fixed-income securities like bonds have had thoroughly inadequate yields. In order to make ends meet, investors have had to research new areas of the market to find enough income.

In this week-long look at various types of income investments, we looked yesterday at mortgage REITs and the double-digit yields they offer. But mortgage REITs aren't the only option for income-hungry investors. Master limited partnerships also produce substantial distributions for investors, and unlike most mortgage-REIT dividends, some MLP payouts have amazing tax benefits. Let's take a closer look at MLPs with the goal of getting more familiar with the way they work and the opportunities and risks involved.

Making your portfolio energetic
Master limited partnerships are publicly traded business entities that focus on the natural resources industry. In particular, many midstream oil and gas businesses that use pipelines and storage facilities to transport and store energy products take advantage of the MLP structure, which allows the business to avoid the corporate taxation that most regular corporations pay. The resulting tax savings gets passed on to MLP unitholders in the form of extra income, and MLPs typically pay out most or all of their income to their investors through sizable regular distributions.

Another benefit for MLP investors is that the distributions the MLP makes are often at least partially tax-free. With MLPs qualifying for special deductions like depletion allowances, substantial portions of what you receive may not count as taxable income.

MLPs do come with some complexity for investors, though. Partnership taxation is beneficial for the business entity, but it brings complications to unitholders, who have to report their proportional share of business income on their tax returns as shown on K-1 partnership tax statements. These statements are often far more complex than the tax forms you get from ordinary stocks and can require accounting help and the attendant cost.

What kinds of MLPs are available?
Pipeline businesses are the most common MLPs, with numerous examples of entities that pay impressive dividends. Energy Transfer Partners (NYSE: ETP  ) has multiple gas pipelines totaling more than 20,000 miles across the U.S., with its most substantial presence in Texas. Currently paying an 8% distribution yield to unitholders, Energy Transfer Partners has made several growth moves recently, including its acquisition of Sunoco to help it diversify into oil pipelines.

But you can find MLPs in other industries. Take these examples:

  • Ferrellgas (NYSE: FGP  ) is an MLP that distributes propane for household and commercial use, with its best-known product being its Blue Rhino refillable gas tanks. It has a current dividend yield of more than 11%.
  • Fertilizer MLPs have become hugely popular, thanks to big demand for crop-yield-enhancing products for farming. Terra Nitrogen (NYSE: TNH  ) and Rentech Nitrogen Partners (NYSE: RNF  ) sport yields of 8% to 9% and have also experienced substantial growth, as relatively low costs of the natural gas needed to produce nitrogen-based fertilizers has reduced overall expenses and boosted margins.
  • Alliance Resource Partners (NASDAQ: ARLP  ) is an MLP that specializes in coal production. The coal business has been depressed due to a lack of demand as many users, especially electric-generating utilities, have turned to cheap natural gas as an alternative fuel source. But despite depressed prices, Alliance has still maintained an attractive dividend yield of around 8%.

As you can see, MLPs come in all shapes and sizes. Although they have the natural-resource thread in common, you can get many different types of natural-resource exposure using the MLP framework.

Risks
MLPs aren't without risk. As operating businesses, they're subject to the same risks that non-MLP players in their respective industries face. For instance, for midstream MLPs, pipeline volumes aren't entirely dependent on energy prices, but producers tend to cut back on drilling and pumping activity when prices are low, which can then reduce revenue for MLPs.

More broadly, some policymakers have targeted MLPs as prospects for tax reform. With the fiscal cliff leading to negotiations aimed at eliminating tax loopholes, MLP tax benefits could potentially be eliminated or reduced for at least some investors in higher tax brackets.

Where else will you find income?
MLPs are definitely worth a close look for income-seeking investors, but if you're not excited about the prospects for energy and other natural resources, they may not be the right answer for you. So where else can you find the income you need? Stay tuned tomorrow as I take a closer look at another income-rich area of the market: dividend ETFs.

Learn more about how Energy Transfer Partners has benefited from the surge in oil and natural gas production from hydraulic fracturing and horizontal drilling. Our new in-depth research report goes through all the details to help you decide whether Energy Transfer Partners belongs in your portfolio. Get your report today; just click here.


Read/Post Comments (12) | Recommend This Article (63)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 19, 2012, at 6:44 PM, afw3 wrote:

    MLP'S are good income but you can't own much of them in an IRA

  • Report this Comment On December 19, 2012, at 6:49 PM, mikecart1 wrote:

    An article about MLPs that is without Kinder Morgan Energy Partners (KMP) is like a mobile phone article without Apple.

    :)

  • Report this Comment On December 19, 2012, at 6:53 PM, hank321 wrote:

    Why not? Why can't you own much of them in an IRA?

  • Report this Comment On December 19, 2012, at 7:36 PM, mciar94 wrote:

    MLP's get special tax treatment. They do not pay federal income tax. They are not allowed in tax deferred accounts because of this. However there are several versions that can be held in tax deferred accounts. These are stock companies that invest in MLP's handle the tax reporting and issue dividends on the stock/ KMI- Kinder Morgan Inc is one that invests in Kinder Morgan Partners MLP. Linn energy MLP also has a version of this but I don't have the stock symbol. Tortoise Energy Partners invests in MLP's TYY and TYG do some research there are ways to get the yields of MLP's in a tax deferred account.

  • Report this Comment On December 19, 2012, at 7:44 PM, tiensman2 wrote:

    If MLPs can not be held in an IRA does that include the ROTH as well?

  • Report this Comment On December 19, 2012, at 7:51 PM, aufergy wrote:

    You can have MLPs in tax deferred accounts such as IRAs. However, it's usually not recommended because you lose the tax benefits by putting them in an IRA. Plus, if you have distributions over $1,000 that income becomes taxable. So, it's possible, just not recommended.

  • Report this Comment On December 19, 2012, at 9:07 PM, maiday2000 wrote:

    You can hold an MLP in a Roth IRA, however, if your total yearly distribution of UBTI exceeds $1000, that money will be subject to taxes. A good article to read is:

    http://seekingalpha.com/article/882601-don-t-be-afraid-to-pu...

  • Report this Comment On December 20, 2012, at 5:47 AM, skypilot2005 wrote:

    Fellow Fools,

    Great / informative comments.

    Thanks.

    Sky

  • Report this Comment On December 20, 2012, at 1:25 PM, 3chains wrote:

    I have held a basket of energy MLPs for a number of years. Thanks to Turbotax, the amount of extra time I spend at tax-time, entering data from K-1 forms, is manageable, about 10 minutes extra per MLP held.

    My favorite is KMR, one of the Kinder Morgan stocks. It pays its distribution in stock, so there are no tax events until you sell.

    MLPs play a large role in my retirement planning, about 10 years away.

    MLPs are fantastic income generators, but please do some research on how they work before you buy.

  • Report this Comment On December 21, 2012, at 1:34 PM, 4farme55 wrote:

    I too like KMR a lot. It's market price tracks the price of KMP quite well. The dividend is the same as KMP's, except it's in stock instead of cash. Good for re-investing.

  • Report this Comment On December 24, 2012, at 6:17 PM, blueed wrote:

    Does the $1000 exemption in a Roth Ira only count per MLP or total income more than one?

  • Report this Comment On January 01, 2013, at 3:37 PM, bobbyk1 wrote:

    I believe you can own LNCO without penalty.

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