Using an IRA to invest can be a great way to defer taxes and save more for retirement. However, there are some complications with using IRAs to hold certain types of investments. In particular, master limited partnerships can have some issues when held in an IRA, and if you're not careful, you can expose what would ordinarily be a tax-deferred investment vehicle to immediate taxation.
MLPs and you
Master limited partnerships are business entities that qualify for the favorable tax treatment of a pass-through entity. That means that MLPs don't have to pay any taxes at the business level, instead having their investors pay taxes on the income that's allocated to them.
In order to get this preferential treatment, an MLP has to get 90% of its income from qualifying sources. Among the allowable sources are income from the production, processing, or transportation of natural resources like oil, natural gas, and coal.
In a taxable account, owning MLPs can get complicated. As partnerships, MLPs issue K-1 tax forms to tell investors how much income, deductions, and other tax attributes are allocable to their interest in the partnership. Dealing with K-1s is more complex than a typical 1099 from a regular corporation, and so the appeal of holding MLP interests inside an IRA can seem appealing. Most of the time, IRA investments wouldn't require any concern about tax issues, because the tax deferral within the IRA would make such considerations unimportant.
The trap of MLPs in IRAs: unrelated business taxable income
With MLPs and other pass-through entities, however, income can trigger special issues in an IRA. Owning such a pass-through entity in a retirement account creates what's known as unrelated business taxable income, or UBTI.
The Schedule K-1 you get from the MLP will include any UBTI figure. If the total exceeds $1,000 from all your MLP investments in your IRA, then a special tax form, Form 990-T, must be completed and sent to your IRA custodian for filing. You'll end up having to pay tax on the UBTI, even though you own the investment in a retirement account.
Except in extreme cases, having UBTI in your IRA won't generally jeopardize its tax-preferred status. However, having a lot of UBTI in a retirement account can generate unwanted attention from the IRS that could lead to an audit.
As tempting as it is to hold MLPs in an IRA, you have to be aware of the risks. Sometimes, doing so could create exactly the problem you're trying to avoid.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!