Geez, how many people are going to buy for their IRA only to find out they have a tax issue?
He should do his homework before making a reckless recommendation like buying for your IRA unless a propane MLP is different than other energy MLPs.
There's no real tax issue. The only issue is that part of NRGY's dividend is return of capital and it will get taxed as ordinary income when withdrawn from an IRA. One of the benefits of NRGY is the beneficial tax treatment that is not received if you own it within an IRA. Better to own it within an aftertax account rather than a tax exempt account such as an IRA.
....Question: Should I hold MLPs in tax-advantaged IRA accounts?
It is not illegal to hold MLPs in an IRA account; however, some of the income you receive from the MLP is unrelated business taxable income (UBTI). UBTI income over $1,000 per year can be subject to tax even though it’s generated by a firm in a tax-free retirement account.
You do not have to pay taxes related to UBTI directly; this tax would be paid by the company acting as custodian on your IRA, and the custodian would also be forced to file the appropriate forms with the government. However, the custodian would pass along those costs to you.
Second, because MLPs are already tax-advantaged it makes sense to hold them when possible in a taxable account. After all, one of the main attractions of MLPs is the tax deferral of return of capital income; you don’t get this advantage inside an IRA account.
There are several MLPs and related investments you can hold in an IRA that do not generate UBTI: Navios Maritime Partners (NYSE: NMM), Kinder Morgan Management (NYSE: KMR) and Kayne Anderson Energy Fund (NYSE: KYE)....
You are right that the distribution is a return of capital; hence, it is tax deferred. This is a come-on bait of the MLP. Also, you are right that the UBTI is taxed if it excesses $1,000 per account.
But..... remember this if MLP stock(s)in your taxable account:
1. While you hold you MLPs stock(s), your partnership interest, items 1 thru 11 of your K-1 form, is taxable.
2. The real whammy is when you sell your MLP stock(s), you have to pay taxes on ordinary gain, partnership interest, and capital gain. If you hold your MLP stocks too long, you may need vasaline ointment for your rear end.
You are right. As long as your cumulative UBTI is less than $1k, there are no negative tax consequences. And you get the joy of getting your K-1 each year and ignoring it.
In fact you can own a fair amount of NRGY and not hit the $1k UBTI trigger. The "common wisdom" number quoted in brokerage reports is the tax shield on NRGY is 80%. That means that in a regular account you would pay income tax on 20% of the distributions you receive in a year. For many MLPs, UBTI is very close (or actually equal to) your taxable income. In 2008 my taxable income was 18% of my NRGY distribution, and my UBTI was 17%. There was also a small amount of qualified dividends, so my total taxable amount would have been close to 20%, as the published tax shield numbers imply.
So using today's 8% yield on NRGY, and using the 20% common wisdom number for the taxable percentage, one could have $62,500 in NRGY held in an IRA, and expect to have $1k of UBTI (simple math: $62,500*.2*.08 = $1,000).
I never 'push the bounds', as UBTI can vary from year to year. For example, if NRGY increases the distribution in 2010 the amount of UBTI will increase. But if I had <$50k in NRGY in an IRA I would NOT worry about hitting the $1k level in 2010 from NRGY alone.
Every year I 'manage' my UBTI in my IRA to make sure I stay under $1k. If I come close one year, I will sell a high UBTI generating MLP to keep it under for the next year. It turns out to be very easy...several of my holdings generate negative UBTI, which can offset positive UBTI's. Given the mix of MLPs I own in my IRA, I would have to be a much richer man than I am before I came anywhere close to $1k.