Master limited partnerships (MLPs) are among the most frustrating sources of yield out there. Yes, it’s common for MLPs to yield in the high single digits and even low double digits, and yes, they enjoy a number of tax benefits. But they also come with a ton of tax hassles, including dealing with K-1s for every one in your portfolio – unless, of course, you invest in one of the three high-yielding MLP funds I’m about to show you.
A quick refresher on the sector…
MLPs must derive a minimum of 90% of cash flows from commodities, natural resources or real estate, which is why most of the MLPs you see out there are related to energy pipelines and storage. They enjoy certain tax advantages as long as they pay most of their earnings out as distributions to shareholders, so they typically throw off extremely juicy yields.
Better still, most of those distributions are taxed as return of capital. That means they’re subtracted from your cost basis, and you’re only taxed only when you sell. If you can get your cost basis down to zero, you get taxed at much more favorable long-term capital gains rates!
And then … there’s the catch.
Note that I said most of the distributions are taxed as ROC. However, about 10% to 20% is taxable income. This, and other MLP tax complications, ultimately falls to you. You have to deal with Schedule K-1 tax forms, which is an inconvenience so big that Vanguard calls it out in its “User’s guide to master limited partnerships”:
“The direct method of investing in MLPs — buying partnership units — involves the receipt of Schedule K-1 tax forms, which some may find too complicated. … Given the risks and complications, MLPs may not make sense for most investors.”
But there’s a better way – you can actually avoid the tax nonsense without foregoing MLPs altogether.
Let’s discuss three MLP exchange-traded notes that gives us yield hunters exactly what we want: the ability to buy into high-yield master limited partnerships without the headache come tax season.