K-1s & IRAs
MLPs turn more difficult when it comes to figuring out your taxes. You have to fill out a K-1 form rather than the simpler 1099 form. And making matters more difficult, sometimes holders have to fill out K-1 forms for each state in which the MLP does business.
"A K-1 from an oil or gas investment can be quite complicated," says Richard Rampell, CEO of Rampell & Rampell accounting firm in Palm Beach, Fla. If you have an accountant, it will generally cost you $100 to $500 for each K-1, he says.
Also, don't think of MLPs as an investment for your retirement account. And why is that? First, since much of the income you receive from an MLP is tax-deferred to begin with, there's no need to put it in a retirement account.
In addition, if you hold MLPs in an Individual Retirement Account, or IRA, you may have to pay a tax on unrelated business taxable income, or UBTI. You can face tax payments on UBTI for income of more than $1,000 per year, even though that income is generated within a tax-advantaged retirement account.
ETFs & ETNs
You can eliminate the K-1 issue by purchasing an exchange-traded fund, or ETF, or an exchange-traded note, or ETN. Both of these represent a basket of MLPs. The distributions are treated as regular dividends for tax purposes. And you can hold these investments tax-free in your IRA account.
But beware that the fees charged by the ETFs and ETNs -- generally 75 to 200 basis points -- will subtract from your dividend. And if you buy an ETN, you face a risk that the note's issuer, a bank or securities firm, may be unable to pay back the note in a time of crisis.
As for choosing MLPs, if you don't go the ETF or ETN route, experts recommend buying at least three or four different ones to provide diversity. To make sure an MLP's distribution is safe, look for those whose distributable cash flow totals at least 1.1 times the payout, Stevens says.
While distributable cash flow isn't part of MLPs' official financial statements, it is usually included in their earnings press releases on the Internet.
Payne recommends larger MLPs for their competitive advantages and solid capital structures. "Go with the best in breed," he says.