What the Heck is a “401(r) Royalty Check” — Tax Free Income?

By Travis Johnson, Stock Gumshoe, December 1, 2009

If you’ve been around the halls of Stock Gumshoe University for a while now, you might know that your friendly and munificent Dean has a soft spot for teasers that invent special coded terms for ordinary investments — so today, I couldn’t resist taking a gander at what the folks at Personal Finance are calling “401(r) royalty checks.”

The name is, of course, a play off of 401(k) plans — much like one of my old favorites, Tom Dyson’s 801(k) teaser from a couple years ago (though the underlying idea is quite different). Here’s how they pitch it:

“It’s a wonder so few Americans have heard of this money secret.

“Unlike regular IRA and 401(k) plans, it lets you draw checks at any time… without any age, income or employment requirements. Every man, woman and child can qualify.

“Depending on your particular situation, your paychecks can be $10,000, $50,000 or more. And best of all, they are virtually tax free!”

There is, of course, no section 401(r) in the Internal Revenue Code, that section stops at 401(o) right now (Internal Revenue is Title 26 of the US Code, in case you’re curious) — in fact, I’m pretty sure that the part that applies to this particular kind of investment starts with section 733, so the 401(r) is, one assumes, just a play on the “royalty” word. They also, though I assume this is a typo, use the term 410(r) a few times — and, no surprise, there is no 410(r) in Title 26, either.

But that’s the academic in me sneaking out for some Code-reading — really, we just want to know how to get these royalty checks, right? Let’s dig into the clues a bit more to discover what Elliott Gue and his marketers are talking about …

First, they throw in plenty of quotes from reputable financial sources to make sure we believe that this isn’t a scam:

“Very few people know they qualify to receive these checks. Or how to collect them.

“For reasons I’ll show you, they aren’t publicized like traditional IRA or 401(k) retirement plans. And that’s why so few people know anything about them.

“In a rare article, Kiplinger’s Personal Finance called them ‘a hidden asset class that Wall Street hasn’t awoken to.’

“I call these payouts 401(r) Royalty checks because, in essence, that’s how they work. They give you a virtually tax-free income you can start collecting at any time.

“As Forbes reported, they are ‘a good place to be during this market funk. They offer good yields, tax breaks and strong growth potential.’

“And as Barron’s stated, these checks are a ‘pay off for taxpayers… offering double-digit returns today.'”

And a bit more …

“401(r) Royalties let you enjoy a worry-free income that’s largely immune to the ups and downs of the stock markets or the economy today.

“It’s easy to see why, when you consider that since their creation in 1987, they have consistently been sending out paychecks for 22 years. Even today, they still pay out a consistent and reliable income.

“According to Alerian Capital, a well-respected firm that monitors 401(r) Royalties, “Many investors look at the historical returns wistfully believing they have missed out and that it must be too late… [but] this asset class is still in its infancy and the opportunity for superior returns over the next decade still exists.”

“I believe 401(r) Royalties are the most stable paychecks you can receive today. There’s simply no other way for you to get this kind of long-term security. That’s why Fortune Magazine concluded that “there’s hope for income-starved investors,” when it comes to 401(r) Royalties.”

Well, that was actually plenty of clues — I have some good news and some bad news.

The good news: I can tell you that these 401(r) Royalty companies are really just Master Limited Partnerships (MLPs).

The bad news: Gue doesn’t tease us about the five specific ones he’s recommending for Personal Finance subscribers, so I can’t tell you exactly which ones he’s pushing.

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But I can, at least, get you started. If you’re unfamiliar with MLPs, they are publicly traded partnerships, created in their current form by a Reagan-era revision to the tax code. They are focused primarily in the natural resources arena, with most of the large and stable ones being pipeline companies. They are set up somewhat similarly to REITs, in that they pay no corporate tax as long as they pass along essentially all of their income to unitholders (the limited partners, anyone who owns a share of the MLP), but there is one big difference: They generally pass along a lot more money than they make, and you can defer taxes on a lot of it. And yes, “no taxes” and “deferred taxes” are very different.

I’m no tax accountant, but this is basically how it works: The partnerships mostly own things like pipelines, storage tanks, and natural gas fields, all of which can be depreciated for tax purposes, often more quickly than they physically deteriorate. They charge big oil companies, natural gas explorers and utilities to gather, transport or store gas, oil, and refined products for them, often under a regulatory regime of set rates, and they take in cash from those customers. They pay the expenses they have to pay to maintain the pipes, and the rest is what they usually call “distributable cash.” You have to take depreciation out of “distributable cash” before you call it “earnings,” so their earnings are usually quite low thanks to the big depreciation bite — but that “depreciation” isn’t necessarily a cash cost, so they still have the cash and they distribute most of it to unitholders.

What that means is that the cash you get as your dividend might be mostly classified as a return of capital — a bit part of it is your share of the depreciation, not actual “earnings,” so it’s not taxable. What that “return of capital” does is reduce your cost basis, so if you own shares of an MLP for a couple decades it’s entirely possible that your tax basis will be reduced to zero — meaning that whatever you sell the shares for is likely to be taxed, in its entirety, at whatever your personal income tax rate is at the time (as I understand it your “returned capital” portion, anything up to the original investment price, would be taxed as personal income, if the price has gone higher the rest of it would be taxed as a capital gain). Basically, this is deferring taxes just like a 401(k) is deferring taxes, though it’s an individual investment so you can buy and sell it wh