I like to take questions from readers, as it gives me a chance to answer some of your investing concerns. Here’s one today that a lot of people saving for retirement are asking:
If Roth IRAs are tax-free, how come I can’t hold master limited partnerships (MLPs) in them?
Because of a quirk in the tax law, Uncle Sam may deem part of your MLP earnings to be Unrelated Business Taxable Income. As stated in IRS publication 598  under “Organizations Subject to the Tax,” if you hold an MLP inside a retirement account, you’ll owe income tax on any UBTI credited to you above $1,000 a year. IRAs including Roth IRAs are subject to this tax. So you should only hold individual MLPs in a taxable account.
And because individual MLPs issue a complex form called a K-1 at tax time instead of a 1099, you may also need a professional tax preparer to help you place all the numbers in the right slots on your return.
Of course, there’s a way around both of these complications: MLP funds. The drawback to a fund is the added layer of operating expenses, which reduce your cash yield. But a fund gives you some important benefits:
- Instant diversification among several dozen MLPs.
- No cumbersome year-end K-1. The fund sends you a simple 1099.
- No UBTI. Appropriate for retirement accounts.
- Dividends may be treated partly (or even mostly) as a tax-free return of capital.
Among the MLP funds currently available, I’m keenest on Alerian MLP ETF (AMLP) and Tortoise MLP Fund (NTG). AMLP is the more conservative vehicle, since it doesn’t use leverage (borrowed money).
On the other hand, NTG will likely throw off a higher yield. Based on its most recent distribution NTG is yielding about 6.2% at the current market price while AMLP is yielding about 5.9%.
As a closed-end fund, NTG can easily wander away from its net asset value (up or down). AMLP, as an exchange-traded index fund, will likely stick pretty close to NAV, because big institutional investors—not you or I—have the right to create or redeem shares at NAV.