Keep Big Government Out of Your Portfolio

This article is published with permission from InvestmentU.com.

It feels like every news story these days is about the government intruding on our lives. The IRS is out of control. And the NSA can monitor your calls, read your emails and tap into your brain to see what you’re thinking. (Well, not yet. Or can it?)

As most people painfully discover each April, the government wants a big chunk of your money for the privilege of following every move you make. Those wiretaps aren’t free, you know.

Fortunately, there’s a way income investors can keep their hard-earned money out of government coffers and it has nothing to do with IRAs or 401(k)s.

If you’re serious about saving for retirement, you max out your IRA and contribute as much as you possibly can to your 401(k).

But after that, we don’t have many options.

Worse, depending on your age, you might actually have to withdraw funds from your retirement accounts. That makes sheltering your cash from Uncle Sam even more difficult.

But there is a little-known way investors can own high-yield stocks in their taxable accounts and ensure the government gets little to none of those dividends.

The secret is an investment called a master limited partnership (MLP).

A different way to invest

An MLP is like a stock in a lot of ways. You buy it through your broker or online brokerage account and they trade on all of the major exchanges. Just like stocks, the price of MLP units (they are not called shares) go up and down based on a variety of factors such as earnings, dividends, and the supply and demand of the shares.

But MLPs are different in a lot of ways, too. When you own stock in an MLP, you are considered a partner, not a shareholder. And dividends are called distributions.

And, of course, the tax treatment of MLP distributions is different from a typical dividend.

For example, if you own 1,000 shares of AT&T (NYSE: T), you’ll receive $1,800 in dividends this year. If you’re in the 25% to 33% tax bracket, you’ll pay a 15% tax rate (worth $270) on those dividends. And if you’re married and your income is over $250,000 (or single and over $200,000), you’ll pay an extra 3.8% — putting $68 in Uncle Sam’s pocket.

An MLP is different.

Most or all of the distribution an investor receives from an MLP is tax deferred. That’s because the payment is not considered a dividend. As a partner in the business (again, you’re not a shareholder), you get a return of capital.

You don’t pay taxes on a return of capital. Instead, it lowers your cost basis.

Here’s how it works.

You buy XYZ MLP for $20. It pays a distribution of $1, all of which is a return of capital. At the end of the year, you will not pay taxes on your $1 distribution. Instead, your cost basis goes down to $19 ($20 — $1 = $19).

You hold the investment for five years, so you’ve collected $5 in distributions. Your cost basis is now $15 ($20 — $5 = $15).

Let’s assume you sell your stake in the MLP for $25. You will be taxed on your $10 capital gain ($25 selling price — $15 adjusted cost basis = $10 capital gain).

So you’ll still have to pay taxes on the capital gain, but for five years, you collected tax-deferred income.

Here’s another great feature of MLPs.

Let’s use our example above where you bought the stock for $20 and received $1 a year for five years. But after five years … you die.

Your heirs get a break. They inherit the MLP’s cost basis at the current market value. That means you collected the income without ever paying taxes and, for your heirs, the tax meter starts at the current market value.

Not bad.

[For full details on how MLPs affect your tax return and what you need to watch out for, click here.]

Good choices

Most MLPS are energy companies. They often operate pipelines. So if you invest in MLPs, be careful not to be too heavily weighted in the energy sector.

Many MLPs generate strong yields. Some well-known MLPs include Enbridge Energy Partners (NYSE: EEP), which has a 7.3% yield; Enterprise Product Partners (NYSE: EPD), which yields 4.4%; and Linn Energy (Nasdaq: LINE), which sports a juicy 9.9% yield.

The idea of Big Brother listening to conversations between me and my wife gives me the heebie-jeebies (although there isn’t much to listen to unless Obama wants to hear us argue over whose turn it is to make the kids’ lunches).

But with MLPs at least investors can keep the government’s hands out of their investment income for the time being.

Marc Lichtenfeld is a senior analyst at Investment U. See more articles by Marc here. For an in-depth write-up on the safety of Linn’s distribution, read Marc’s analysis from Wealthy Retirement.