With April 15 just around the corner, if you're like me, you're looking for ways to permanently reduce your tax bill. The good news is that there are investments that not only cut your taxes, but also deliver high yields. Some of these are small niche investment vehicles and not well-known. But with the right tools, you can be smarter than the crowd and use these to your advantage.
1. Master Limited Partnerships (MLPs)
Master limited partnerships (MLPs) have a track record for consistent growth, steady returns and high yields that are mostly tax-free. In addition, many energy MLPs own oil and gas pipelines and are poised for strong growth right now because of renewed domestic drilling, which is increasing demand for pipelines and terminals for transportation of these resources.
A benchmark MLP index yielded 6% last year, and several MLPs currently offer payouts near 8%. The MLP sector is relatively new, but proved its resiliency during the recession, when only a handful of MLPs cut distributions. So while these vehicles might not be barn-burners in terms of price performance, they offer relatively safe, stable dividends with a moderate degree of price return to boot.
A portion of MLP payouts are often tax-deferred, creating tax advantages for investors. In fact, due to big depreciation allowances, as much as 90% of the distribution is classified as return of capital and not taxable in the current year. Instead, return of capital reduces the cost basis of the MLP investment and isn't taxed until units are sold (ownership in an MLP is in "units" rather than shares).
For example, if you pay $25 for a MLP unit and receive $4 in distributions ($3.50 of which is a return of capital), the cost basis of your investment declines to $21.50 after the first year ($25 minus $3.50) and you pay no taxes on the $3.50 until you decide to sell.
You maximize the tax deferral benefit by holding MLP units for longer periods. These are especially attractive investments if you plan to retire in a few years and will be moving into a lower tax bracket.
MLPs I especially like include Enbridge Energy (Nasdaq: EEP), which owns pipelines in the mid-continent and Gulf Coast regions and is spending $110 million to expand gathering capacity. In the past two years, Enbridge increased distributions 8%, and units currently yield 7%.
Kinder Morgan (NYSE: KMP) owns 37,000 miles of pipeline near the Haynesville Shale and the Eagle Ford Shale regions. This MLP has posted 16 years of distribution gains, is guiding for 8% distribution growth this year and yields 5%.
Terra Nitrogen LP (NYSE: TNH) produces nitrogen fertilizer for farmers, nearly tripled distribution payments last year and yields 8%.
REITs own shopping centers, apartments, office buildings and other properties. A feature unique to REITs is that they pay no corporate taxes as long as they distribute the majority of profits (usually 90%) to shareholders.
Since REITs pay no corporate taxes, REIT dividends don't qualify for the 15% dividend tax rate. However, while the dividend portion of the distribution is taxed as ordinary income, other portions receive more favorable tax treatment. For example, part of the payment may be distribution of capital gains triggered by the sale of a property. This portion is taxed at the 15% capital gains rate. Another portion may be return of capital and not taxed until shares are sold.
REITs suffered badly during the real estate collapse and many were forced to cut dividends. Only a few were able to increase payments. Nursing home operator National Health Investors (NYSE: NHI) has posted 10 years of dividend growth and yields 5%. Universal Health Realty Income (NYSE: UHT) has raised dividends 22 years in a row and has a 6% yield.
Washington REIT (NYSE: WRE) is well on its way to becoming a Dividend Aristocrat. This office REIT has a 39-year record of dividend growth and yields 6%.
3. Municipal Bond Funds
Municipal bond funds can be great fixed income investments, particularly if you are in a high tax bracket. These funds invest in the municipal bonds that states, cities and counties issue to fund capital improvements.
Municipal bonds are exempt from federal income taxes and also sometimes exempt from state taxes. Due to tax advantages, these bonds usually yield less than other bond types. You can compare what a taxable bond would have to yield to match your tax-exempt return by calculating the tax equivalent yield (TEY). Simply divide the municipal bond fund yield by one minus your tax rate. For example, if a fund yields 6% and your tax rate is 20%, then a taxable fund would need to yield 7.5% (6% divided by 1 minus 0.20) to give a comparable return.
Some big fund companies like BlackRock, Eaton Vance and J.P. Morgan are rolling state bonds into larger multi-state funds, so be sure to check the fund portfolio before you buy. Their aim is to reduce risk from state budget shortfalls, but co-mingled funds could leave investors on the hook for state taxes. Also look at maturity dates. Bond prices move inversely to interest rates, and the biggest price swings occur for bonds maturing far in the future. Also look to invest in no-load funds that hold these securities, since high expense ratios can quickly eat into profits.
Municipal bond funds that have performed well include PowerShares Insured National Muni Bond (NYSE: PZA), which yields 4.3% and returned 19.4% last year, and Market Vectors Long Municipal Index ETF (NYSE: MLN), which yields 4.3% and returned 22.5%.
The Investing Answer: MLP and REIT distributions aren't guaranteed, so check that the business generates enough cash flow to cover distributions. You maximize the tax benefits of MLPs and muni bond funds by holding these investments in a taxable account. The opposite is true for REITs. Since REIT dividends are taxed as ordinary income, REITs are best held in a tax-deferred retirement account.
All three of these asset types provide tax advantages and high yields. Of the three, municipal bond funds are probably the least risky, REITs are the most risky and MLPs fall somewhere in between. Be sure to do your own due diligence, but the securities I mentioned earlier should provide a good starting point for further research.
P.S. -- If you're interested in tax-advantaged high yields, we've just put together a presentation called "The Top 5 Income Stocks for 2012" that contains some of our favorite REITs and MLPs. Go here to view the presentation now.