The “Taper” Factor
When Ben Bernanke uttered the word “taper” on June 19, the markets jittered. Even the traditionally defensive sectors such as utilities took a hit.
MLPs were not immune to the potential implications of the Fed easing up on its bond-purchase program which many believe is helping the US economy. The market panicked, and MLPs dropped in price. Readers will note the index dropped in the middle of 2013. The drop was less steep than those in either the broad market or the utilities sector and MLPs rebounded—in less than a week, while it took approximately three weeks for both the S&P 500 and XLU to get back to their June 18 levels.
When evaluating a potential candidate, a prudent investor will see how they have performed during times of market volatility. Sometimes trading a bit of yield for much less volatility is a smart move.
The IRA Caveat
We do not recommend putting MLPs in an IRA account. By placing an MLP in a tax-deferred account, you may lose part of the tax advantage the MLP structure provides. In an IRA account, unrelated business taxable income (UBTI) of over $1,000 is subject to federal income tax. If you earn more than $1,000 annually from an MLP’s cash distributions and other sources of UBTI, the excess will be taxable. This becomes more likely over time, since most MLPs increase their cash distributions.
A Peek Behind the Curtain
In summary, an MLP gives us a couple of advantages from a tax perspective. There is more money to pay out in dividends. Unlike a traditional corporate dividend, which is paid after a corporation pays income taxes, MLPs do not pay corporate income taxes. An MLP’s income is taxed only once, when the dividends are received.
Initially, when you buy an MLP, only 10 to 20 percent of the MLP distribution is considered taxable income. The rest of the distribution is considered return of capital and isn’t subject to tax when you receive the dividend. Basically you put off paying some taxes for the short term. When you eventually sell your MLP, the tax is adjusted so the net amount of taxes is the same. The formula is technical, but the information you receive from your broker can be given to a competent CPA and you should be fine.
You can see why MLPs have become so popular in a yield-starved environment. While they have attracted a lot of investors, there are still some great opportunities for those willing to do their homework.
Dennis and I added our favorite MLP to the Money Forever portfolio in October, and we are chomping at the bit to share it with you… But, because of the special relationship we share with our paid subscribers, you’ll need to sign up to for a premium subscription at no-risk to your pocketbook to find out what it is. Subscribe to our regular monthly newsletter and take a peek at the MLP we recommended, along with our entire portfolio. If, after 90 days, you decide it’s not right for you, we’ll return 100% of your money without a fuss. Click here to get started.