Articles

MLPs do not Play Nicely with IRAs by Jeffrey M. Mutnik, CPA/PFS


Posted on February 15, 2016 by Jeffrey Mutnik

Investing in master limited partnership interests (MLPs) comes with a multitude of traps and foibles, for which investors should keep their eyes wide open. A recent article in The Wall Street Journal describes a common situation that turned into a tax nightmare   because the investors were unaware of the potential for an investment in an IRA to be taxed in the current year.

 

Consider the following scenario: Jane Investor meets with her financial advisor. Part of her financial assets consist of a Roth IRA worth $500,000.  Through a series of questions and interviews, the advisor determines that Jane’s risk tolerance is low.  The advisor builds a suitably conservative portfolio of stocks and bonds included within the IRA.

 

Jane’s husband John Investor also has a $500,000 Roth IRA account. However, in deeming John’s risk tolerance to be considerably higher than Jane’s, the advisor builds a more aggressive portfolio for John. Because John knows that income generated within the Roth IRA will avoid taxation today and that any future distributions from the account will not be considered taxable income, he instructs the advisor to use his Roth account for the most aggressive investments within his overall portfolio. He expects that this strategy will yield greater than normal returns tax free.

 

Jane and John each sign documents allowing the advisor the latitude to build their portfolios. They review their statements with glee, as each portfolio grows through the year.  However, they do not dwell on the details of what the accounts actually own.  Specifically, since the Roth accounts are tax-free (unlike a tax-deferred standard IRA), they pay no attention to the underlying portfolio assets in those accounts.

 

Does this scenario sound familiar? Do you know what’s next for Jane and John?

 

Jane sails through the year realizing 6 percent growth of her Roth IRA with no tax issues within the account.

 

John assumes his investment strategy paid off with his Roth IRA realizing 10 percent growth for the year. However, the wind is soon taken from his sails when he discovers that his account includes various MLPs that made money during the year and are subsequently treated as taxable business income.

 

MLPs are liquid because they are traded like stocks. However, they do not provide investors with dividend income that is reported on Form 1099-DIV.  Rather, the MLP’s activity flows through to the owner on the Partnership’s K-1.  If an owner is lucky enough to have invested in a partnership that does well, such income is considered business income inside an IRA, which is taxable to the IRA in the year earned.  Thus, the expected tax advantages of an IRA will not materialize.  Worse, the IRA will pay tax using compressed rates, which will increase the investor’s tax liabilities.

 

Investors must pay attention to the underlying assets and finer details included in all of their investments. For Jane and John, their best option is to divest of all MLP investments in their IRA accounts to avoid potential current taxation and in their taxable accounts to avoid potential state tax implications.  They should also consult with their tax accountant and financial advisor, together, to create a less taxing portfolio that retains appropriate segment exposure to meet their risk tolerance.

 

About the Author: Jeffrey M. Mutnik, CPA/PFS, is a director with the Taxation and Financial Services practice of Berkowitz Pollack Brant Advisors and Accountants, where he provides tax and estate-planning counsel to high-net-worth families, closely held businesses and professional services firms. He can be reached in the CPA firm’s Ft. Lauderdale office at (954) 712-7000 or via email at info@bpbcpa.com.