A typical trade-off for most high-yield investments is that they pay non-tax-qualified dividends, which would be taxed at your marginal income tax rate. Not a lot of investors know that there is a way (outside of qualified retirement accounts) to earn tax-advantaged, high-yield dividends.
The benefits can be substantial.
So let me show you how to do it…
Stock dividends can be tax-qualified or not. Regular corporations pay qualified dividends. The dividends are taxed at a lower rate because the companies pay corporate income taxes. Qualified dividends are taxed at a 20% rate. Non-qualified, or ordinary dividends are taxed at your regular income tax rate, up to 37%. And that’s just federal income tax—state tax can pile on top of this!
Ordinary dividends are paid by real estate investment trusts (REITs) and business development companies (BDCs), which operate as pass-through entities. They don’t pay corporate income tax if they pay out at least 90% of their income as dividends.
To summarize: qualified dividends are taxed at a lower rate because the companies pay corporate income tax. Ordinary dividends are taxed at a higher rate because the paying companies don’t pay corporate income tax.
Then we get to master limited partnerships (MLPs). The MLP business structure is mainly confined to the energy infrastructure sub-sector. These are your pipeline, storage, and terminal operating companies. If you invest in a publicly traded MLP, you are officially a limited partner. As an LP, the tax advantages flow through to you.
The end result is that the dividends/distributions paid by an MLP are tax-advantage to the point that you will pay no taxes on the dividends potentially forever. The trade-off is that, as an LP, you receive a Schedule K-1 for tax reporting. K-1s require a little more work at tax time.
Here are five popular MLPs and their current yields:
- Energy Transfer LP (ET) yielding 9.5%
- Enterprise Product Partners LP (EPD) yielding 7.5%
- Magellan Midstream Partners LP (MMP) yielding 7.7%
- MPLX LP (MPLX) yielding 8.9%
- Plains All American Pipeline LP (PAA) yielding 8.2%
These MLPs pay excellent yields and are also growing their distribution rates.
To avoid the hassles of K-1 reporting, my recommended MLP ETF is the InfraCap MLP ETF (AMZA), which pays monthly dividends and currently yields 8.8%.
