When it comes to retirement accounts like IRAs, the promise of tax-deferred growth is a central appeal. However, as many investors discover too late, not all investments are well-suited for these tax-advantaged accounts. Master Limited Partnerships (MLPs), while often attractive for their high yields, can bring about significant tax complications within an IRA that undermine the very benefit of deferral. Let’s delve into why owning an MLP in an IRA is not just a bad idea—it can also be a costly mistake.
The Unwelcome Reality of Unrelated Business Taxable Income (UBTI)
At the heart of the issue is something called Unrelated Business Taxable Income (UBTI). When an MLP generates more than $1,000 in UBTI within an IRA, it triggers the need to file Form 990-T. This form, typically reserved for tax-exempt entities, ensures that your IRA pays taxes on that UBTI. In essence, your IRA, which you expect to grow tax-free or tax-deferred, suddenly becomes subject to taxation.
The problem doesn’t stop at the complexity of filing Form 990-T. Because this income is taxable within the IRA, any taxes owed must be paid directly out of the account—funds that were supposed to be growing untouched for your future. The surprise? This creates a scenario where the benefits of tax deferral are eroded by immediate tax liabilities.
Taxation and Administrative Complexity
While most investments held in an IRA benefit from simple tax rules, MLPs are a different beast. MLPs distribute Schedule K-1s to their investors, detailing income, deductions, and other financials. But for IRAs, much of this information is irrelevant, with the critical focus being on UBTI. Still, even the task of monitoring UBTI from year to year becomes an administrative burden many are unprepared for.
Worse yet, many financial institutions outsource the preparation of Form 990-T to third-party accountants. This often results in errors, sometimes in the investor’s favor but often to their detriment. The complexity of MLP taxation means that mistakes can easily lead to overpayment of taxes or, worse, unpaid taxes with penalties and interest accruing over time. For most IRA investors, who seek simplicity and tax efficiency, this complexity represents a needless headache.
A Real-Life Example: The Costs of Mismanagement
Let’s consider a real-life scenario. An investor holds MLP units in their IRA, assuming all income and growth are tax-deferred. Over time, the investment grows, and the MLP continues to generate UBTI. When the investment is finally sold, the combination of accrued UBTI, capital gains, and suspended losses results in a significant tax liability. Without careful planning, the taxes owed can run into the tens of thousands, depleting the IRA balance that was expected to fund retirement.
The problem is further compounded when the fiduciary managing the IRA is slow to file amended returns or fails to properly document tax filings. Penalties, interest, and misallocated income are all too common in these situations, leaving the investor scrambling to recover funds that should have remained untouched for retirement.
UBTI Suspended Losses: An Overlooked Danger
One of the most frequent mistakes in handling MLPs within an IRA is overlooking suspended UBTI losses. When these losses aren’t applied correctly at the time of the MLP’s sale, taxable income can be overstated, leading to a larger tax bill than necessary. Unfortunately, many brokerage firms and third-party tax preparers fail to properly account for these losses, leaving investors paying more in taxes than they rightfully owe.
Suspended UBTI losses carry forward from year to year and are deductible upon the sale of the MLP. However, if the Schedule K-1 from prior years isn’t available or accurately reviewed, these losses can go unclaimed. In cases like these, reconstructing the history of UBTI and cash distributions from MLP websites becomes critical, though tedious, to recalculate what is truly owed.
Capital Gains and Debt-Financed Property: Another Layer of Complexity
In addition to UBTI, MLPs held in IRAs can also generate taxable capital gains, especially when debt-financed property is involved. The tricky part? Only a portion of the capital gain may be taxable, depending on the debt ratio. This percentage must be calculated based on the average acquisition indebtedness and the average basis of the debt-financed property, figures not always readily available. This adds yet another layer of complexity and potential risk for the IRA holder, as miscalculations here can lead to overpayment of taxes or missed deductions.
The Fiduciary’s Role: Filing the Amended Return
When errors occur, it’s not always a simple matter to correct them. The fiduciary of the IRA is responsible for reviewing and signing amended tax returns, but this can cause delays, especially if the fiduciary lacks tax expertise. Even when a personal accountant prepares a corrected Form 990-T, the fiduciary may hesitate to sign it without extensive documentation, further delaying the recovery of misallocated IRA funds.
The Bottom Line: There Are Better Options for Your IRA
For most investors, the complexity, tax liability, and administrative burden of holding MLPs within an IRA far outweigh any potential benefits. The UBTI problem can eat away at the very tax-deferred growth that an IRA is meant to provide, and the long-term compounding effect of these taxes can lead to substantial depletion of your retirement assets.
Rather than exposing your IRA to unnecessary tax complications, consider alternative investment vehicles better suited for tax-advantaged accounts. Almega recommends maintaining simplicity, transparency, and tax efficiency in your retirement portfolio. While MLPs can be a strong investment in a taxable account for the right investor, they are a poor fit for IRAs—an investment choice best avoided for long-term financial health.
Bryan Wisda is a CERTIFIED FINANCIAL PLANNER™️ and a NAPFA-registered financial Advisor. He is the President of Almega Wealth Management, a boutique wealth management firm that provides successful families with investment consulting, advanced planning, and relationship management services from its offices in Arizona, Kentucky, and North Carolina. Bryan has over 31 years of experience working in the financial services industry; he is most known for helping successful families create a life beyond wealth.