The master limited partnership (MLP) sector is hot because it offers a combination of capital appreciation and a relatively high level of income. However, MLPs are not stocks, and that's important to remember because thinking of them as a stock can lead to a big retirement mistake you'll want to avoid.

What is an MLP?
According to the National Association of Publicly Traded Partnerships, "MLPs (master limited partnerships) are publicly traded partnerships: limited partnerships which are traded on stock exchanges. A share in an MLP is called a 'unit,' and owning MLP units makes you a limited partner."

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While that may sound like double speak, the key word is partnership. Still, when you buy a stock, you own a small piece of a business. Being a limited partner means you own a small piece of a business, too. The notable difference comes at tax time.

Corporations are taxed as separate entities. They pay taxes and then send dividends to investors, if they choose to. Partnerships aren't taxed at the corporate level, and unitholders are responsible for paying taxes on partnership income. You get to sort out the taxes when you get your K-1, which is the tax document MLPs send unitholders that outlines your piece of the partnership's income, expenses, and tax deductions.

And that's what makes MLPs desirable and tricky. It's also why consulting a tax professional is a good idea if you own, or are planning to buy, an MLP.

So what does this mean?
First off, because MLPs avoid double taxation, you'll usually get more in distributions than you would by owning stock in a company operating in the same or similar business. Second, because tax deductions like depreciation and amortization are also passed down to unitholders, a portion of the distributions you receive will not be subject to income tax.

Generally speaking, some portion of the distribution will be considered a return of capital, which reduces your tax basis in the units. You'll effectively pay capital gains taxes on those distributions when you sell the shares because your cost basis will be lower. Thus, with tax advantaged distributions, you get the money now and pay taxes, most likely at a lower rate, later.

Now, with a little background, you'll better understand how to avoid a big MLP retirement mistake, for most of us at least: owning MLPs in a tax advantaged retirement account like a traditional IRA or Roth.

What's the mistake?
Why is owning an MLP in a tax advantaged account such a mistake? First the easy reason: The distributions are tax advantaged. You'll be wasting that benefit if you put an MLP into a retirement account that is itself tax advantaged. However it gets worse with traditional IRAs, since money pulled from such accounts are taxed at your full income tax rate. That could effectively nullify any tax benefit from owning an MLP.

For this reason alone, you should probably avoid owning MLPs in retirement accounts, but it gets even more complicated because though you can legally own MLPs in retirement accounts, if you do, your IRA or Roth becomes the partner—not you. That's a subtle but important distinction.

The Internal Revenue Service has created something called unrelated business income tax (UBIT). It's a little obscure, but, according to the National Association of Publicly Traded Partnerships, "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."

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The midstream business run by Enterprise Products Partners (EPD -0.31%), for example, has nothing to do with an IRA's tax-exempt status. Thus, the IRA would have to pay taxes on UBTI the IRA earned from owning Enterprise—not you. What?

"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." And, to add insult to injury, those taxes are paid at the highest tax rate for a trust.

There is, of course, a wrinkle. A retirement account can earn up to $1,000 of UBTI before it has to pay taxes. Tax is owed only on UBTI above that level. But, once again, this diminishes the tax benefit of owning an MLP, and that's in addition to the potential for making your life more complicated at tax time.

Get some help
MLPs are complicated beasts, making the services of a tax advisor highly desirable. That said, it isn't hard to avoid the tax headache of owning MLPs in retirement accounts—just don't bother. Generally speaking, it's a mistake you'll want to avoid if you want to get the maximum benefit from your MLP investments.