Can You Hold MLPs in an IRA Without Tax Issues?

Master Limited Partnerships (MLPs) offer attractive yields and tax advantages, making them popular among income-seeking investors. However, holding MLPs in an Individual Retirement Account (IRA) can introduce unexpected tax complications. Understanding how MLPs interact with IRA rules is essential to avoid potential tax liabilities and compliance issues.

Holding MLP Units in an IRA

MLPs are structured as pass-through entities, meaning they do not pay corporate income tax. Instead, their income, deductions, and credits flow directly to unit holders, who report them on personal tax returns. While this structure provides tax benefits in a taxable brokerage account, it creates complications in an IRA.

A key issue is how MLP distributions interact with an IRA’s tax-deferred status. Unlike dividends from traditional stocks, MLP distributions are classified as a return of capital, reducing the investor’s cost basis rather than being immediately taxable. In a taxable account, this deferral continues until the units are sold, at which point capital gains taxes apply. However, in an IRA, cost basis adjustments do not matter because gains and losses are only recognized upon withdrawal. This can lead to unexpected tax consequences when MLP units are eventually sold.

Another complication arises when an MLP is sold inside an IRA. The IRS requires that accumulated depreciation and other deductions taken over the holding period be treated as ordinary income, known as “recapture.” This recaptured income is taxed at ordinary rates, which can be as high as 37% in 2024. Because IRAs do not allow capital losses or deductions to offset this income, investors may face a higher tax burden than if the MLP had been held in a taxable account.

Unrelated Business Taxable Income

IRAs generally shield investments from annual taxation, but certain types of income can trigger immediate tax liabilities. One major concern when holding MLPs in an IRA is Unrelated Business Taxable Income (UBTI). The IRS taxes UBTI to prevent tax-exempt entities, including retirement accounts, from gaining an advantage when engaging in business activities that compete with taxable businesses.

MLPs often generate UBTI because they operate in industries like energy infrastructure, where revenue comes from business operations rather than passive investments. The taxable portion of an MLP’s earnings is reported annually on Schedule K-1. If the UBTI allocated to an IRA exceeds $1,000 in a tax year, the IRA must file Form 990-T and pay tax on the excess. This tax is paid from the IRA’s assets, reducing the account’s value.

Holding multiple MLPs in the same IRA increases the risk of exceeding the $1,000 UBTI threshold. The IRS aggregates UBTI across all holdings, meaning even modest amounts from individual MLPs can add up. Some MLPs also experience fluctuations in UBTI from year to year, making tax liabilities unpredictable.

Tax Filings Within an IRA

When an IRA generates taxable income, the account itself—not the individual owner—is responsible for compliance. IRAs are treated as separate tax entities under IRS rules, meaning they must file their own tax forms and pay any applicable taxes from their assets. For MLP investors, this typically means dealing with Form 990-T. Failure to file can result in penalties and interest, reducing the retirement account’s value.

Most IRA custodians do not handle tax filings unless specifically instructed, leaving investors responsible for ensuring compliance. If the IRA owes tax, it must also make estimated payments throughout the year. These payments are due quarterly, and missing deadlines can result in underpayment penalties. Some custodians charge additional fees for processing tax filings, adding to the cost of holding MLPs in an IRA.

As of 2024, the failure-to-file penalty starts at $435 or 5% of the unpaid tax per month, whichever is greater, up to a maximum of 25%. Additionally, underpayment penalties apply based on the IRS’s fluctuating interest rate. These costs can add up quickly, particularly for investors unaware of their filing obligations.

Traditional vs. Roth IRA Considerations

The type of IRA used to hold MLPs affects the long-term tax consequences, especially at the time of withdrawal. Traditional IRAs offer tax-deferred growth, meaning contributions reduce taxable income in the contribution year, but withdrawals in retirement are taxed as ordinary income. If an MLP investment grows significantly, investors may face higher tax rates on withdrawals than they would have if the same investment had been held in a taxable account, where capital gains rates apply.

Roth IRAs provide tax-free withdrawals in retirement, assuming the account meets the five-year holding requirement and the owner is at least 59½ years old. However, any tax liabilities incurred within the IRA, such as those from Form 990-T, must still be paid from the account’s assets, reducing the benefit of tax-free growth. Since Roth IRA contributions are made with after-tax dollars, investors do not receive an upfront deduction, making it less appealing to hold investments that could generate tax obligations before retirement.