Letters

Taxation on Sale of MLPs in an IRA

Comments on “Making Sense of Master Limited Partnership Tax Rules,” by Mary Lyman, in the November 2012 AAII Journal:

What’s missing in this article is taxation on sale of an MLP [master limited partnership] in an IRA. Also, how is the tax paid? Meaning, who prepares the tax statement?

— Gerald Lanois from Florida

Mary Lyman responds:

Thanks for your comment. I generally don’t get into the issue of taxation on the sale of an MLP in an IRA unless specifically asked because it is not a completely settled issue (the IRS has never ruled on this question) and I am not a tax adviser.

It is clear that the portion of gain from the sale that would be taxed at the capital gains rate in a capital account will not be taxable to the IRA. The question is: Does the IRA have to pay tax on the recapture portion, the amount that is taxed as ordinary income in a sale from a taxable account? Of the MLP tax experts I’ve consulted—some tax lawyers, some accountants—some feel that there’s an argument to be made that the transaction would be completely tax free to the IRA. Others argue that there is only one interpretation—that because the tax code gives precedent to depreciation recapture over any other rule, the recapture amount is treated as unrelated business income and the IRA must pay tax on it. All agree that the IRS would take the latter position; the only question is which position would prevail in the Tax Court and any subsequent appeals. Again, I don’t give tax advice, but the safest route is probably to assume that recapture applies.

The article actually does indicate how the unrelated business income tax is paid, as does the material on the subject on the NAPTP (National Association of Publicly Traded Partnerships) website: It is the responsibility of the plan’s custodian—for example, Fidelity if you hold your IRA in a Fidelity account—to file the appropriate tax return (Form 990-T) and pay the tax out of the IRA’s funds. Perhaps I should have emphasized this more, as there is a of lot confusion among investors about how it affects their taxes. If you are the beneficiary of the IRA, it has absolutely no effect on your taxes—the IRA itself is the taxpayer owing money to the IRS and any tax payments come out of its funds, not yours.

Target Date Funds’ Investments

Comment on “Target Date Funds: A Simple Premise, but Underlying Complexities,” by Charles Rotblut, CFA, in the October 2012 AAII Journal:

I appreciate the article written by Charles Rotblut on target date funds. Lots of good material included. One of the issues that concerns me is that most target date funds invest more in growth stocks than value stocks and in large-cap rather than small-cap stocks. This is inconsistent with the long-term results determined by many analyses that value outperforms growth over time and small-cap stocks outperform large-cap stocks. It is a mystery to me why all the target date funds are structured in reverse of what would be optimal.

— Tony Hausner from Maryland

Selling Bonds Before Maturity

Comment on “Using Bonds Instead of Stocks for Portfolio Income,” by Stan Richelson and Hildy Richelson, in the October 2012 AAII Journal:

The article recommends buying and holding individual muni bonds to maturity. If an investor does that, they will know exactly what the return will be. A major caveat is what happens if the investor decides to sell the bonds before maturity.

You have no guarantee what the bid price will be or even if there is a bid price. For higher-quality issues like the article suggests, this is less of a problem, but it is still a problem. If a broker bids to buy your bonds, the price may be disappointingly low, particularly for small lots that individual investors typically have.

The other major issue is the implicit assumption of low inflation. The article recommends buying bonds that mature in 15 to 23 years that yield approximately 3.5%. If inflation remains constant at 2.0% for 23 years, the real return will be 1.5%. If inflation picks up in the next 23 years, the real return might be substantially lower.

— Greg Bayless from Texas