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MLPs and Retirement Accounts

Investors often ask if they can invest in MLPs through their retirement accounts--IRAs, 401(k)s, and similar plans which are allowed to earn tax-deferred income under the Internal Revenue Code. The regular cash distributions offered by MLPs make them an appealing possibility for investors wishing to build up retirement funds.

You Can, But ….

The answer is yes, IRAs, 401(k)s, and other qualified retirement accounts are allowed to invest in MLPs the same as any other traded security. There is nothing in the federal tax code or pension laws that says they cannot.

More importantly, contrary as it may seem, holding MLPs in a retirement account can result in the account owing tax.

Unrelated Business Income Tax

There is a concept in the tax code (I.R.C. §§511-514) called “unrelated business income tax” (UBIT)
Under the UBIT rules, tax - exempt organizations and retirement accounts must pay tax on their “unrelated business taxable income” (UBTI) - income from a business that is not related to their exempt purpose (a university operating a business that had nothing to do with education would be an example).

If your IRA invests in an MLP, it becomes a limited partner in that MLP, just as you would if you invested directly. Because an MLP, like all partnerships, is a pass - through entity (no tax is paid by the partnership, all tax items flow through to the limited partners/shareholders, who pay tax on their share), the partners are treated by the tax code as if they are directly earning the MLP’s income.

Thus, as a partner in the MLP, the IRA or other account is considered to be “earning” its share of the MLP’s business income.
The MLP's business is not related to the retirement account's tax -
exempt purpose; therefore the IRA's share of the MLP's income is treated as UBTI and is taxed accordingly.

The tax is owed on the retirement account’s share of the MLP’s
taxable business income, minus its share of depreciation and other deductions related to the business, as reported on the K–1 form
(not on the quarterly distributions). The K-1 contains a line reporting how much UBTI the MLP is passing through. The tax rate is the highest tax rate for a trust currently 39.6%.

There is a deduction that covers the first $1,000 of UBTI from all sources; after that, the retirement account will owe tax.
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