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Chris Dumont Dec 11, 2014
Be sure to also see the 10 Mutual Funds for Hard-to-Reach Places.
Moreover, MLPs have appealed to investors for two reasons: high tax favored yields and a play on the U.S. energy boom. As of December 31, 2013, 110 of 135 MLPs were energy firms consisting of an MLP market cap of $491.3 billion.
As with any investment, there are risks with MLP mutual funds. Because MLPs must operate in certain industries, they can be overexposed to that industry, which is typically energy. Energy is cyclical and as oil prices rise and fall so does the MLP, even if it is a mutual fund providing some form of diversification.
Furthermore, while MLPs on their own aren’t subject to federal tax, mutual funds that hold the partnerships don’t enjoy the same advantage, which weighs on returns. Investors may still choose to go with MLP mutual funds rather than regular MLPs due to the convenience. It is important to note that individual investors that invest in MLP mutual funds get a big portion of the distributions at a tax advantage, allowing investors to put off tax bills until they sell, which eventually makes them eligible for lower, long-term capital gain rates.
Lastly, MLPs are managed by a general partner and the limited partners pay a fee for this service. The management expense fee can be relatively high so be sure to look at the MER before making any investment. At the same time, it is in the general partner’s interest to grow the MLP’s earnings and increase distributions.
Be sure to also see the 7 Essential Tax Tips for Mutual Fund Investors.
The benefit is that because MLPs do not pay corporate taxes, there are more earnings to be available to the investor. Furthermore, the distributions are treated as a form of tax-deferred return of capital. As distributions are received as return of capital, it also reduces the tax basis of the partnership units and these are not taxed at the investor’s current income. This occurs until you’ve gotten back the full amount of your original investment. Not only are you receiving several percent a year, you’re not paying taxes on it either.
The tax implications for MLPs are complex and it’s recommended to hire an accountant to get more information and also to deal with the extra paperwork involved. Investors will receive a K-1 for, which will reflect the investor’s share of income and losses of the MLP and must be included on the tax return. Also, MLPs are not attractive in tax-deferred IRAs because the partnership may generate taxable income in any given year.
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