(Editor's note: This is the first in a series of weekly columns on retirement by Jim Cramer, founder of TheStreet , and Wally Konrad, former senior editor for Smart Money magazine.)NEW YORK ( TheStreet) -- Income. It's the holy grail of retirement and there's not much of it. Master limited partnerships are a nice exception. Their yields of 6%-plus look fabulous compared to anemic Treasury bond and CD rates. No wonder they're attracting retirement investors in droves. Unfortunately, there's a catch. MLPs can be a great retirement investment but a terrible retirement account investment. Put an MLP in your IRA or 401(k) and you'll miss out on some great tax breaks. What's more, you might get charged with additional taxes you weren't expecting. Here's the good news. MLPs don't pay corporate taxes. Instead, taxes are considered "pass through," meaning liabilities and expenses are passed on to investors. MLP investors may write off partnership expenses -- depreciation, etc. -- against income on their tax returns. Quarterly income distributions from an MLP are often considered a "return of capital," which means no taxes until the investor sells the MLP. What's more, there's still plenty of growth potential left for MLPs. Here's the not-so-good news. These breaks aren't allowed if the MLP is held in a retirement account. "If you put an MLP in an IRA or your 401(k), which is already tax advantaged, you miss out," says Mary Lyman, executive director of the National Association of Publicly Traded Partnerships. Here's why MLPs have a good news/bad news story. Like a limited partnership, an MLP is a business conducted by two or more lead partners and several other partners acting as investors. Unlike most limited partnerships, MLPs trade "units" on an exchange. In order to be considered an MLP, the partnership must earn 90% of its revenue from activities relating to natural resources, commodities or real estate. Most MLPs these days concentrate on transportation and storage of oil and natural gas. That big jolt of yield comes from the fact that MLPs pass cash flow onto a steady stream of income for investors. That structure is also what gives MLPs their tax advantages and why they don't work so well with retirement accounts.
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.
Nonetheless, diversity is no small consideration when it comes to oil and gas investments. "People forget that these are exchange-traded investments," says Willoughby. "Just like oil and gas stocks, these investments are volatile." At the least, if you're invested in MLPs, be sure the rest of your portfolio doesn't have too much exposure to energy investments.