One of the biggest benefits of using an IRA, be it Roth or traditional, is the tax advantage -- particularly the ability to grow your investments completely tax-free inside the account, including dividends and even realized gains when you sell. However, master limited partnerships -- commonly called MLPs -- can leave you owing taxes, even if you own them in an IRA.
With the tax benefits being the biggest reason to save for retirement with an IRA, the tax implications make MLPs a no-go in that type of investment account. Keep reading to learn about MLPs, how to identify them, and more about why they're best avoided in your retirement accounts.
What an MLP is (and why it can lead to taxes on your IRA)
In short, an MLP isn't a company and doesn't pay corporate income taxes; it's a kind of partnership that passes along its income to its owners, called partners. MLPs are generally in the energy or some other natural resources industry, and almost always generate steady cash flows and pay a large dividend.
And it's this dividend -- it's actually a distribution that is not technically a dividend -- that can lead to the tax consequences. In short, MLPs are tax-advantaged entities, and that's why they exist. The lack of income tax allows the assets owned and operated by the MLP to be more cash-flow efficient.
But just because the MLP doesn't pay taxes, it doesn't make the tax burden go away: It's simply passed along to its owners, which, in the case of publicly traded partnerships, is you, the unitholder (MLP-speak for shareholder). As an MLP investor, you'll receive a schedule K-1 each year, instead of a form 1099, that you'll use when you file your taxes.
And you may end up having to pay taxes on your MLP investment inside of an IRA because of something called unrelated business taxable income, or UBTI. In most, though not all, cases, this income is directly related to the distributions paid by MLPs. In other words, you might end up owing tax on income you weren't even paid.
But it's mainly about the distributions
In general terms, the distributions paid by MLPs often generate a significant amount of these investments' long-term value. For instance, two of the best MLPs are Magellan Midstream Partners, L.P. (NYSE:MMP) and Enterprise Products Partners L.P. (NYSE:EPD). And their ability to pay and regularly increase distributions has contributed the vast majority of investor returns (returns from the distribution are calculated by subtracting stock price change from total returns):
Paying taxes on those gains in your IRA negates the biggest reason to use an IRA in the first place: tax avoidance.
Being tax-savvy will help you reach your retirement goals
Traditional and Roth IRAs let you avoid taxes on capital gains and dividends for all of the years you invest before retiring. Your traditional IRA can help cut your tax bill while you're working. Your Roth can help you cut taxes when you retire. Owning MLPs in your retirement account will take a bite out of that benefit, leaving you with less money when you retire than you could have accumulated otherwise.
Don't get me wrong -- as the chart above shows with Enterprise Products Partners and Magellan Midstream, well-run MLPs can be excellent investments. But they belong in your taxable accounts, not in your IRA, where they'd be wasting an important benefit.