Yes, you can invest in a master limited partnership (MLP) for your Roth individual retirement account (IRA), but you’ll need to be aware of the special tax rules on these investments. The rules become especially tricky when your MLP investment within an IRA earns more than a certain amount.
Key Takeaways
- You can hold master limited partnership (MLP) investments in a Roth or traditional individual retirement account (IRA).
- Unlike other IRA investments, however, MLP income over $1,000 annually is taxable.
- If you want MLP exposure in your IRA without the tax consequences, consider an exchange-traded fund (ETF) that tracks an MLP index instead.
How Master Limited Partnerships (MLPs) Work
A master limited partnership (MLP) is a security issued by a partnership in the style of company stock. An MLP issues units instead of shares, and these units are often traded on national stock exchanges. MLPs were made more attractive after the Tax Reform Act of 1986, which allowed companies with primary business activities in real estate and natural resources to issue units of their partnerships to the public.
MLPs are popular among investors when interest rates are low, making their relatively high yields attractive. At the same time, they tend to be more volatile than stocks and bonds, and may be best suited for sophisticated investors with a higher risk tolerance than the average investor.
How MLPs Are Taxed in a Roth IRA
Because the units of an MLP represent an interest in the partnership, any income that they produce is considered a partnership distribution and is taxable as such. A company that issues MLP shares doesn’t pay corporate income tax but instead distributes income to its partners or unitholders. This becomes taxable income to the shareholder.
When you hold MLP shares within an IRA, such as a Roth IRA, any income that you earn above $1,000 annually is considered unrelated business taxable income (UBTI). That makes it subject to immediate tax, unlike most other investments that you might hold in an IRA, where your earnings are usually tax deferred or, in the case of Roth IRAs, tax free when you make withdrawals in retirement. Investing in an MLP in a Roth or traditional IRA essentially eliminates the tax benefits of these retirement accounts on any income that you earn over $1,000.
If you are interested in exposure to MLPs in your Roth IRA, but you would rather avoid the possible tax headaches, consider investing in an exchange-traded fund (ETF) that tracks an underlying MLP index. You’ll get the diversification that MLPs can add to a portfolio while keeping the tax advantages of a Roth IRA. Or, as an alternative, buy the MLP units for a regular, taxable account.
How are master limited partnerships (MLPs) taxed in an individual retirement account (IRA)?
In a Roth or traditional individual retirement account (IRA), master limited partnership (MLP) income over $1,000 is considered unrelated business taxable income (UBTI) and is taxable. In other words, you’ll pay taxes on any income above $1,000 that the MLP earns annually.
What are the tax advantages of a Roth IRA?
Contributions to a Roth IRA are made in after-tax dollars, which means that they aren’t tax deductible. But earnings grow tax free and you don’t pay taxes on qualified distributions.
When can I withdraw from a Roth IRA?
You can withdraw contributions to a Roth IRA at any time. You can withdraw earnings without owing taxes or penalties when you’re age 59½ or older, if the account is at least five years old.
The Bottom Line
Earning more than $1,000 from an MLP in your Roth IRA will result in a tax bill, which negates the tax advantages of this retirement account. If you want MLP exposure in your Roth or traditional IRA, consider an ETF that tracks an MLP index instead.
If you’re still tempted to buy units in an MLP for your IRA, either a Roth or traditional one, it’s worth consulting a tax advisor to work through the tax implications. Another option is to buy MLP units in a taxable investment account instead of an IRA.
Advisor Insight
Rebecca Dawson
Dawson Capital, San Mateo, Calif.
Yes, you may own MLPs in your Roth IRA, but there are some potentially unfavorable tax consequences to doing so. IRAs are subject to taxes on a special type of income called unrelated business taxable income, or UBTI. The distributions paid by MLPs are likely to be considered UBTI.
If a Roth IRA earns $1,000 or more of UBTI annually, the UBTI income above $1,000 is subject to tax even if the securities are held in a retirement account, which is typically not taxed. If your retirement account earns $1,000 or more per year in UBTI, you have just eliminated the tax advantage of your retirement account.
It is usually a good idea to hold individual MLPs in a taxable account vs. a retirement account.