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

by Travis Johnson, Stock Gumshoe | December 1, 2009 12:32 pm

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[1] 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[2]’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[3] 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[4] 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[5] 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[6] (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.

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[7], 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[8] fields, all of which can be depreciated for tax purposes, often more quickly than they physically deteriorate. They charge big oil[9] companies, natural gas explorers and utilities[10] 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 whenever you want — regardless, you do eventually, unless you pass the MLP shares along to your heirs, have to pay the tax you’re deferring — so part of your calculation might be your expectation about whether the tax rate you pay is going to be substantially lower or higher in the future, when you sell the shares. Let me be clear, again, that I’m not a tax expert and you should not rely on my thoughts when doing your planning — there’s a more detailed article here from Investopedia if you’re curious about how this works[11].

So what you have, in effect, is a way to get current income from your investment and defer taxes on it for pretty much as long as you like. For some people, MLPs are almost an ideal investment — but of course, they do carry some risk, too, even beyond the risk that tax rates could be considerably higher when you end up paying for the income from your MLPs whenever you decide to sell the shares. There are MLPs and other publicly traded partnerships in several sectors that take on whatever business risk exists in that sector, and most of them have a general partner who runs the operation and takes a sweetened share of the cash (there are a few general partners who are also publicly traded). Probably the best overall look at MLPs, albeit from a group with a vested interest in promoting the structure, is this primer from Alerian, which created the MLP index [pdf file][12]. MLPs, as measured by Alerian’s index, have dramatically outperformed the S&P500, utilities, REITs, bonds, and commodities over the past five and ten years (as represented by the major indexes, like the FTSE NAREIT index and the DJ UBS Commodity index).

There are some oddball partnerships that own things like money managers (AllianceBernstein) or cemeteries (StoneMor, which I’ve profiled for the Irregulars[13]), fertilizer[14] (Terra Nitrogen, probably the most successful partnership in recent years) and agriculture[15] (ML Macadamia Nut Orchards), but the vast majority are in energy, including interstate pipelines and gathering pipelines for natural gas and oil, refineries and refined product pipelines, distribution pipelines and networks, and storage of all of that flammable gas and liquid stuff.

If you’re looking for a MLP investment in the traditional midstream/pipeline mold, it’s hard to go wrong with the big guys — Enterprise Products Partners, Kinder Morgan Energy Partners, Energy Transfer Partners, Plains All American Pipeline, ONEOK Partners and the like. Those are all huge, multibillion dollar firms that are the top holdings in the Alerian index, and they tend to have fairly diversified operations compared to some of the smaller firms — be sure to check all of them out if you’re curious, of course, but in general these big guys will be more reliable. Once you get down to smaller MLPs you find that they often are heavily reliant on gathering pipes for one gas field, for example (the pipes that gather the gas from the wells, and the processing plants that get it into the big pipelines), or one product in one region, and that can always bring more volatility if that gas field happens to get shut in — as was the case with some natural gas fields when gas was cratering in price earlier this year, and could still be the case if prices remain relatively low in the future. You also might look at growth, if you want your distributions to grow quickly you’d like a MLP that’s growing its assets by building extensions or acquiring smaller operators.

And if you want to see which MLPs Elliott Gue likes the most … I don’t know whether he tells his Personal Finance subscribers about the same investments as he uses in his new (and much more expensive) MLP-focused newsletter, MLP Profits[16], but I did write about a teaser for that new service over the Summer that included three of his then-favorite picks, mostly smaller MLPs[17] that I didn’t mention above.

If you’re thinking about risks, it’s useful to think about the different kinds of pipelines and assets these firms own — which is why I generally feel more comfortable with the larger and more diversified MLPs, despite the fact that they therefore might have muted returns compared to riskier partnerships. In general terms, MLPs are pretty steady because they operate on long-term contracts for many of their pipes, and they operate kind of like toll roads, charging a set fee for the service — they don’t rely on gas prices rising or falling in a given day, for example, to make a profit, broadly speaking they just rely on continuing demand for the products they transport and process.

But that said, here are some of the more specific risks: Gathering and processing assets run the risk that the fields they serve are being depleted, which limits their usable life span, and that the field could be, particularly if it’s an expensive one, shut in if prices collapse. Refined product transport pipelines are largely dependent on gasoline demand, so if gas prices skyrocket they might suffer — assuming that the price is rising due to supply constraints, not demand increases. Storage demand is a function of many things, but one of them is investors and speculators — when gas prices fall, some investors might buy up storage space to hoard gas for a time when prices rise, if folks think prices have peaked there might not be as much demand for storage. Propane distributors/retailers, a small subset of the MLP world, are dependent largely on residential heating demand, so the weather will play a large role in their income (ie, a warm winter = less cash coming in). And as transporters of petroleum products, all of these companies face regulatory and environmental risks of one sort or another.

If you think this is a fabulous sector but don’t wish to deal with the tax headaches of K-1s and the additional recordkeeping required, there are a couple oddball stocks and some funds that you can use to get exposure to the MLP sector … the oddball stocks are LLCs that essentially hold shares of the partnership and issue you dividends[18] in new shares instead of in cash, which gets rid of some of the annual tax headache — the ones I know of are Kinder Morgan Management (KMR) and Enbridge Energy Management (EEQ)[19]. Those still require some recordkeeping, since you’re getting new shares as a “dividend” every quarter, but at least I don’t think you have to wait for the annual (often late) K-1 to come in the mail before you can do your taxes. (Did I mention I’m not a tax expert?)

If you choose to use a fund to invest in MLPs, you get MLP-like income without the K-1 hassle or tax headaches, but you sign yourself up in many cases to pay a ridiculous annual expense ratio (which may, of course, be sometimes justifiable if the managers are creating real value), and you lose all of the tax-deferred benefits of being a limited partner. You also get diversification and, in some cases, management screwups, as with the closed-end funds[20] that used leverage[21] and got clobbered during the worst of the credit crisis. The closest thing to an index ETF is the JP Morgan Alerian Index ETN (ticker AMJ), which is a note, not a fund (so it’s technically debt — the credit risk is with JP Morgan, and the coupon is based on the distributions paid out by the MLPs in the index, less fees). That ETN charges .85% for annual expenses, pretty high for an index but a lot lower than the closed-end funds.

The closed-end funds I’m aware of that have a substantial MLP focus are the Fiduciary/Claymore MLP Opportunity Fund (FMO); Kayne Andersen Energy Total Return (KYE), Energy Development (KED) and MLP (KYN); Tortoise Energy Capital (TYY), Energy Infrastructure (TYG), and Capital Resources (TTO); MLP & Strategic Equity (MTP); Energy Income and Growth (FEN); and Cushing MLP Total Return (SRV). Most of those have annual expenses of at least 2.5%, often far higher, use leverage to boost their returns (which is common among closed-end funds, but almost killed a lot of them last winter), and trade at a substantial premium to net asset value, sometimes as high as 15-20%.

I know many of my readers like these funds, but I personally think they cost too much for what you get, especially right now when MLPs are a relatively favored investment getting a lot of attention and driving up premiums for the funds — if you’re willing to deal with the tax headaches (and benefits), you could easily distribute your portfolio among half a dozen MLPs that are at the top of most of these closed-end fund portfolios (you can see the details on each of these funds here at the Closed-End Funds Association website[22], most of them hold a lot of the same big MLPs that I mentioned above — just use the ticker box at the top right of that page to enter the name or ticker of any of the funds).

I generally like MLPs, though I often find it hard to distinguish among them and the large ones often move in unison and pay similar distributions (most of the big guys pay around 7.5% now, with their prices having recovered since last year). I currently own Boardwalk Pipeline (BWP), though that one is a little more aggressive than some, and have owned Kinder Morgan (KMR) in the past, and probably wouldn’t hesitate to buy any of the others near the top of the Alerian index if the prices fall and my portfolio’s got room for them. I know there are a lot of you out there who like and depend on the MLPs for income, so feel free to share your favorites or comment on the sector — that’s why we’ve got the friendly little comment box below.

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