Idea$ 2014 - June: Tax-efficient investments

Taxpayers are always looking for ways to accomplish the wealth trifecta - preserve principal, generate income, and minimize taxes.  Yet accomplishing this feat is very challenging due to a number of external factors.  In order to preserve principal, investors must often sacrifice higher returns for less risky investments, which reduces income.  Riskier investments have the potential to generate higher returns (income), but they also present the risk of loss of capital.  Furthermore, investments that generate income subject the investor to a higher tax rate.  As you can see, it's easy to find investments that meet 2 out of 3 of these criteria, but winning the trifecta is much more difficult.  Following are some alternatives for taxpayers looking for tax-efficient investments.  

Municipal bonds

Municipal bonds (muni's) are tax-efficient in that the income they generate is typically not taxable at the Federal level and, if planned correctly, at the state level.  Muni's are bond issues for municipalities such as cities, counties or school districts.  Muni's, like all bonds, are sold at a premium or a discount depending on the bond's yield at the time of sale.  

Interest on municipal bonds is always tax-exempt at the Federal level.  Each state is different, but in Arkansas, all interest earned on Arkansas municipal bonds is tax-exempt to Arkansas.  For example, an Arkansas taxpayer with municipal bond interest from school districts in Arkansas and Texas will only pay Arkansas tax on the interest from the Texas school districts.  

Beware that tax-exempt income is a preference item for the alternative minimum tax.  Investors considering substantial investments in tax-exempt bonds should consult their tax adviser to verify that the interest will not subject them to the AMT.  

Master limited partnerships

Master limited partnerships (MLPs) have gained popularity in recent years for their favorable tax treatment.  Investors enter into MLPs as a partner.  During the year, they receive distributions from the partnership that are not taxable.  Then, at the end of the year, the investor receives a Form K-1 reporting their share of income and losses.  

Although it is possible for the K-1 to report income to the partner, due to non-cash expense items the distributions typically exceed the amount of income on the K-1.  The downside to owning units in an MLP is that, upon sale, a portion of the gain (if any) is reported as ordinary income.  See additional information regarding investing in MLPs in a previous article regarding owning MLPs in a retirement account.  

Practical considerations

Tax-efficient investing is best suited for investors that desire to preserve principal in their investments and also do not have many deductions to offset their taxable income.  A young taxpayer with children at home, dependent care expenses and a mortgage can afford to generate more investment income because their effective tax rate will be lower as a result of their deductions.  However, a taxpayer with no children and few deductions will benefit more from tax-efficient investing.  

IRA tax on MLP earnings

Investing in a publicly-traded Master Limited Partnership (MLP) can be a savvy move for some investors.  This is because the MLP, unlike a common or preferred stock, is taxed as a partnership.  In doing so, the earnings of the MLP are distributed to its members on a Form K-1, instead of through dividends or capital gains.  What's even better is that most MLP's make a distribution on a regular basis.  This distribution might appear to be a dividend, but it is not, because the taxpayer is paying tax on the earnings, not the distribution.  Here is an example:

Randy owns 100 units of ABC MLP, a publicly-traded partnership.  The taxpayer receives four quarterly distributions of $100 each, for a total of $400.  At the end of the year, Randy receives a K-1 from ABC which shows $50 of ordinary income.  On Randy's tax return, he will report $50 of passive income on his Schedule E.  The $400 from a tax perspective is basically forgotten, to be deposited into Randy's brokerage account for other investments or reinvested in more units of ABC MLP.

MLP's are also commonly known to have high distribution yields, such as in Randy's situation above.  He received $400 of cash during the year for his investment, but only had to report $50 on his tax return.  How do they do it?  Many MLP's take advantage of tax deductions such as depreciation and domestic production activities in order to reduce their taxable income below their book income.  These deductions are not cash expenses, which allows the MLP's to distribute high amounts of cash even though their taxable income is low.  Good for the MLP, and good for the investor.

Because of their high distribution yields, many investors choose to hold MLPs in their retirement accounts.  From a tax perspective, this is where the situation gets a little dicey.

Retirement accounts, such as IRAs and 401(k)s are technically considered tax-exempt entities.  There is a little known rule that if these entities earn something called Unrelated Business Taxable Income (UBTI) over a certain threshold, they are required to report that income to the IRS and pay tax.  The threshold is $1,000, and the tax rate is 39.6% (gasp)!

Let's go back to Randy, and now he owns 5,000 units of ABC MLP in his IRA.  He receives $20,000 in distributions during the year, and his IRA receives a K-1 with $2,500 of ordinary income.  The IRA is the partner in the MLP, not Randy, so the IRA will have to file a Form 990-T and pay tax of $594 ($2,500 - $1,000 exemption = $1,500 x 39.6% = $594).  It is not Randy's responsibility to file this return; the custodian of the account will do the filing and use money from the IRA to pay the tax.  This scenario shows how a tax-savvy investment in a tax-exempt account just became taxable.

In summary, individuals that hold MLPs in retirement accounts should monitor their positions to ensure that they are not losing any of their retirement savings to taxes.  Those that are interested in making significant investments in publicly-traded MLPs should consider doing so in taxable accounts, the main reason being that the individual tax rate will most likely be lower than 39.6%.