Consider this. Partnerships held in a retirement account can get caught in an arcane tax rule called unrelated business taxable income. You pay this when cash distributions from an investment are considered unrelated to the structure that gives an entity its tax-exempt status.
In plain English: Income from oil and gas is unrelated to saving for retirement, so the IRS wants you to pay some taxes on it.
This usually affects only investors with big stakes in MLPs, but it can rear its ugly head if you have a particularly successful hit.
Some analysts believe that UBTI is no big deal in a retirement account because it's actually the custodian's responsibility to file these taxes, not the individual's."Technically, that's true, says Lyman. "But what we hear from investors is that many times their custodians don't really have a clue what to do." And, even if they do, it's likely they'll charge a fee for these services, says Mark Willoughby, principal at Boston-based Modera Wealth Management. One more tax angle to keep in mind no matter where you park an MLP: If the partnership operates across state lines you may have to file taxes in each of those states, a cumbersome and sometimes costly process. Bottom line: If you invest directly in MLPs, it's best to hold them in a brokerage account and take full advantage of the tax breaks and high yields. Out of the 90-plus publicly traded MLPs, those worth considering include Kinder Morgan Energy Partners (KMP), Enterprise Product Partners (EPD), MarkWest Energy Partners (MWE) and Energy Transfer Partners (ETP). (The latter is held in the Action Alert PLUS portfolio. We like the partnership's large portfolio and increasing shift toward natural gas, not to mention the 7.6% yield.) For diversity's sake, some advisers suggest investing in exchange-traded funds and open and closed mutual funds that focus on MLPs. Shareholders in these accounts are not subject to UBTI taxes so they can easily put the funds in retirement accounts. The rub: extremely high fees. Because the fund companies are not considered "pass through" entities, they pay corporate taxes on MLP earnings. To do that, they charge high fees. Plus, total returns are often lower than you might get from individual MLPs.
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