High-Yield Investing Tip: MLPs
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Taxes may be confusing to some, but they are also important to overall returns. That's why my research isn't finished until I know how the income paid by an investment will be taxed.
Most MLP distributions are comprised of about 20% net income and 80% return of capital (which is really just an allowance for depletion or depreciation). The income portion is generally taxed at your ordinary income tax rate.
You don't pay taxes on the return of capital portion until you sell the security, making MLPs ideal for long-term investors. Return of capital distributions lead to a reduction in your cost basis. If you pay $50 a share for an MLP, for example, and receive a $5 return of capital distribution this year, then the cost basis of your shares declines to $45. If you sell the shares next year for $55 a share, you'll be taxed at your ordinary income tax rate on the $10 in capital gains ($55 less $45).
If the owner of the security dies, the reduced cost basis is stepped up to the current share price. That makes MLPs good for estate-planning purposes, as they don't trigger a tax liability for your estate.
There is one glitch with MLPs. Individual MLPs aren't suitable for individual retirement or other tax-deferred accounts because they generate a type of income called "unrelated business taxable income" (UTBI). If your retirement account earns more than $1,000 of this income, then you'll end up paying taxes on it. As a result, you probably want to hold MLPs in a regular brokerage account.
You can skirt around this tax issue by opting for a closed-end fund that invests in MLPs, such as the Kayne Anderson Energy Total Return Fund (NYSE: KYE). These funds handle the complexities of K-1 forms, Schedule E and out-of-state returns that may be required for owners of individual MLP securities.
These funds don't throw off unrelated business taxable income. They generate dividend income that is reported on a simple 1099 form instead of the somewhat more complex K-1 used by an individual MLP. They also offer the benefits of holding a basket of MLPs with diverse income sources. Management expenses can be much higher than with other funds, though thanks to their tax and diversification benefits, MLP funds remain an excellent choice for many investors. |
