The power of dividend growth investing to generate long-term wealth and help people meet their financial dreams, such as a prosperous and sustainable retirement, has been well documented.

Many investors are aware of dividend aristocrats; companies like ExxonMobil (NYSE:XOM), Johnson & Johnson (NYSE:JNJ), and Walmart (NYSE:WMT), who have increased their dividends for 25+ consecutive years. This article explains three reasons why Master Limited Partnerships (MLPs) are an investment class that compares favorably to dividend growers such as these and could be a good candidate for your diversified long-term income portfolio.

What are MLPS?
MLPs are publicly traded limited partnerships that derive at least 90% of their cash flows from real estate, commodities or natural resources. In the US there are about 120 MLPs with a combined value around $875 billion.

There are three classes of MLPs: upstream (resource extractors like oil and gas partnerships), midstream (those that transport and process resources, like pipeline operators), and downstream (refiners and distributors). 

Rather than paying dividends to shareholders, they pay distributions to unit holders. Another difference is that most midstream MLPs have a general partner, who runs the partnership. Limited partners (investors) don't have a say in how the MLP is run. In addition, general partners typically hold incentive distribution rights (IDRs), which means that a higher proportion of the MLPs marginal cash flow goes to them as the distribution grows (up to 50% of marginal cash flow). 

There are three main drawbacks to MLPs. The first is that those partnerships with a general partner will experience slower distribution growth over time, as IDRs increase. Second, MLPs issue K-1 forms which are used instead of 1099's and can add a bit of complexity during tax preparation. Finally is the fact that they shouldn't be used in tax deferred accounts such as IRAs. This is because they can generate what's known as UBTI (unrelated business taxable income) that can result in you owing taxes even though the investment is in a tax deferred account.

Why then do people bother with MLPs and why should you? The answer lies in five key attributes of this investment class.

Reason one: high and growing yield
The first two reasons to love MLPs are high and fast growing yields. MLPs are pass through entities, meaning that as long as they pay out almost all of their earnings as distributions they don't pay taxes. This results in substantial yields that typically grow over time as the partnership acquires or builds new assets, such as additional oil wells or new pipelines.

Company Yield Historical Dividend/Distribution Growth Rate Projected Dividend/Distribution Growth Rate Beta
Kinder Morgan 4.60% 13.79% 11.02% 0.61
S&P 500 1.97% 5.05% 5.05% 1

Sources: Yahoo Finance, Mutlpl.com, Fastgraphs

The above table highlights one of my favorite midstream MLPs, Kinder Morgan Inc (NYSE:KMI) 

Kinder Morgan Inc is actually a general partner to three MLPs, Kinder Morgan Energy Partners (NYSE:KMP), Kinder Morgan Management (NYSE:KMR), and El Paso Pipeline Partners (NYSE:EPB) but recently announced it was buying out its partnerships in a $71 billion deal that will make Kinder Morgan a regular dividend paying corporation. I include Kinder Morgan because, as one of America's oldest MLPs, it helped define the industry and establish the characteristics that have made it a favorite among income investors over the past quarter century. After the merger is complete it will be, in my opinion, one of the best dividend growth and retirement stocks in America

Thanks to consistently excellent management and long track records of fast distribution growth, Kinder Morgan has rewarded long-term investors with market thrashing total returns (which take into account distribution reinvestment).

KMP Chart
KMP data by YCharts

Reason two: tax benefits
The main reason investors put up with the tax headaches of MLPs' K-1 forms is that typically only 10%-20% of the distribution is taxable income. The rest is "return of capital" that is subtracted from your cost basis. This means that over a long enough time period, you'll be able to withhold your entire purchase cost from the IRS, only paying taxes if and when you sell. If you never sell and pass the investment onto your heirs then the taxes will be permanently deferred. Once your cost basis hits zero, all remaining distributions are taxed as long-term capital gains, which for most investors means 0% or 15%. 

This site provides an excellent resource for learning more about the tax ramifications of MLPs and for personalized recommendations you can consult a fee-based certified financial advisor

Reason three: low volatility 
As Credit Suisse's John Edwards recently told The Energy Report, the infrastructure of most MLPs:

"is typically contracted on a fixed fee basis, making the basic economics of that arrangement less volatile than the economy generally. That helps explain why MLPs are less volatile than the broader economic markets."

Lower volatility can be a powerful investing asset, especially for certain income investors such as retirees who depend on investments to fund expenses and who care more about preserving wealth than capital gains.

MLPs can offer income investors a powerful combination of three attributes that maximize the chances of not just earning considerable income, but also generating long-term market beating total returns as well. Their high and growing yields, deferred tax benefits, and lower volatility means that every dividend investor should at least consider whether MLPs deserve a position among your diversified income portfolio. Keep in mind that, just like stocks, all MLPs are not created equal, and investors should read this guide on buying MLPs before making a decision. 

 



Adam Galas has no position in any stocks mentioned. The Motley Fool recommends Johnson & Johnson and Kinder Morgan. The Motley Fool owns shares of Johnson & Johnson and Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. 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.