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Do These Investments Belong in Your IRA This Tax Season?

By Aimee Duffy – Jan 25, 2014 at 1:14PM

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If you're looking to pad your IRA before tax time, you might want to think twice before doing it with MLPs.

In preparation for tax season, many investors are trying to find the best stocks to buy with the cash they inject into their retirement accounts before the April 15 deadline. Given the growing popularity of the master limited partnership vehicle, more investors than ever before are wondering whether or not to put MLPs into their IRAs.

The short answer is no, you should not put an MLP into your IRA. Note that it is perfectly legal to have MLPs in your IRA. If you are already in this situation, you are not breaking any rules.

The IRA is a tax-exempt vehicle, meaning you do not pay taxes on your holdings until you are ready to draw down. However, you could pay taxes if any of the holdings in your account generate something called unrelated business taxable income, or UBTI, in excess of $1,000.

For example, if you own three MLPs in your IRA that generate $400 of UBTI each, your account could be subject to paying taxes on $200, or the UBTI generated in excess of $1,000. 

This does not happen if you hold MLPs in your brokerage account. It is also not likely to be an issue if you hold a small position (or positions) in an MLP in your IRA and never trigger the $1,000 threshold. Most advisors will tell you to avoid the whole issue and keep MLPs out of IRAs.

There are two ways to put MLPs in your IRA without having to worry about the UBTI issue. The first is to simply buy an exchange-traded fund, like the Alerian MLP ETF (AMLP 0.49%). ETFs are taxed like corporations, which means you don't have to worry about anything if you put it in your IRA. It also means, however, that you are subject to the ETF's management fee, which varies by fund.

The other exception would be to buy institutional shares, or i-shares, for your IRA. Right now, investors' options in this regard are limited to Kinder Morgan Management (NYSE: KMR) and Enbridge Energy Management (NYSE: EEQ).

Shares of these two entities are essentially carbon copies of units in Kinder Morgan Energy Partners (NYSE: KMP) and Enbridge Energy Partners (EEP), respectively, that pay quarterly distributions in the form of more shares, versus cash. Come tax time, they send out 1099s instead of K-1s. This allows institutional investors to buy them and meet reporting requirements, something they cannot do (or is too complicated to do to make it worth it) with entities that issue K-1s. It also means they do not generate UBTI and are hassle-free options for an IRA.

Clearly, this is a non-starter for some investors given there are only two i-share options on the market right now. That said, if you are already interested in either Kinder Morgan or Enbridge, you should know about this IRA-friendly option.

Bottom line
Remember, MLPs are tax-advantaged structures to begin with. Why jeopardize that status by putting it into an IRA? Instead, if you are intent on owning MLPs, use your brokerage account and leave the IRA to the ETFs and C-corps.

Fool contributor Aimee Duffy has no position in any stocks mentioned. The Motley Fool recommends Enbridge Energy Partners, L.P.. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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