The 4% Withdrawal Rule Versus Required Minimum Distributions, Part Two

Karin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Please be sure to read Part One before you read this part. In it, I discuss the very real possibility that a retiree, if his money is invested in a tax-deferred account such as a traditional IRA  or a 401(k), may be forced to withdraw more from his account than the recommended 4%.

 So you find yourself in the somewhat enviable position of being required to withdraw more annually from your IRA of 401(k) than you actually need or want to spend. You don’t want to spend this “extra” money, but you can’t put it back into the account from which you withdrew, and you can’t open a new tax-deferred IRA. 

But there is still one way to get tax-deferred income, without the use of a tax-deferred investment account.

Another option – Master Limited Partnerships

The option that I really like is to open a taxable investment account, but to fill it with Master Limited Partnerships, or MLPs.

An MLP is great in an income portfolio, because it pays out a large part of its income as distributions to its partners, i.e. shareholders. These distributions are then subject to a very favorable tax treatment, which makes investments in these types of partnerships extremely attractive. Specifically, there are two advantages that can benefit the investor: The first is that, as a partnership, the income is not subjected to corporate income taxes, which allows more of the income to be passed along to the partners.

Secondly, the distributions of an MLP are not considered income under the current tax code. They are considered a return of capital, and thus are not taxable to the receiver; they do, however, reduce the cost basis of the investment itself. Thus, when the investor finally sells, his cost basis will be reduced by the amount of distributions that he has received, so his taxable gain will be more. Therefore, you will only pay the tax on the distributions when you actually sell your position, and it will be considered capital gains.

You will still be assessed a share of the partnership's actual net income every year, but this tends to be significantly less than the amount of distributions, and is also reduced by the partnership's deductions for depreciation.

In other words, an MLP pays out a high percentage yield to its partners, and most of that yield is tax-deferred. What could be more perfect for someone who is not eligible for tax-deferral via a traditional IRA?

My recommended MLPS

I’ve been examining dividend-paying stocks and MLPs for quite a while now, using a proprietary system that I developed to rate companies based on a combination of 7 factors: Dividend yield; number of years raising dividends; 5-year dividend growth rate (DGR); forward 5-year earnings growth rate (EGR); PE ratio; dividend payout ratio; and total return over the past twelve months.

I chose ten companies for my Perfect Dividend Portfolio, of which 2 are MLPs. I present them here for your consideration.

High yield plus share price growth

My first recommendation is Enterprise Product Partners (NYSE: EPD), which was the third company that I selected for my portfolio back in December. At the time, Enterprise Product Partners scored an 18 on my system, and I continue to re-score it every few months, to make sure it still is performing as I want.

The company is currently trading at approximately $61, up from $50, where it was trading when I chose it, and yields 4.3%, which is actually down from the 5.3% it initially was yielding, as the share price has increased more quickly than the dividend.

With that said, the partnership has been raising its dividend for 15 years: Its last increase was for the current quarter, when it was raised from 66 to 67 cents, an increase of 1.5%. The distribution was raised every quarter last year and has so far been increased twice this year. The partnership's 5-year DGR is 5.7%, which is on the low side for what I like, but still greater than the rate if inflation.

The partnership has returned 25.8% over the past twelve months. The analysts’ 5-year annual earnings growth estimate is 12.2%, the company’s PE is 21.9 and its dividend-payout ratio is 93%.

Enterprise Product Partners still scores very well on my ratings system, with an increase to 19 points since I selected it. I am very pleased with its inclusion in my portfolio. 

Lower current yield but higher dividend growth

My second MLP is Sunoco Logistics Partners (NYSE: SXL), which I selected for my portfolio in January. The company is currently trading at approximately $62, up from $58, where it was trading when I chose it, and yields 3.8%.

The partnership has been raising its dividend for 10 years, and its last increase was for the current quarter, when it was raised from 54.5 to 57.25 cents, an increase of 5%. Sunoco Logistics has raised its dividend every quarter for 5 years. The partnership has returned 68% over the past twelve months, yet the dividend has remained high thanks to the 5-year average dividend growth rate of 13%. The analysts’ 5-year annual earnings growth estimate is 12.2%, the company’s PE is 21.9 and its dividend-payout ratio is 93%.

Sunoco Logistics Partners still scores very well on my ratings system, with an increase to 20 points since I selected it. This is currently one of my favorite companies.

A third excellent MLP

If I were to choose a third MLP for my Perfect Dividend Portfolio, it would be Plains All American Pipeline (NYSE: PAA), which I have examined several times but have chosen not to include in my portfolio at this time. ( I already have two MLPs and Williams Company, which is another energy pipeline company, in the portfolio.)

The partnership is currently trading at approximately $58, it yields 3.9%, and it has been raising its dividend for 13 years. Its last increase was the current quarter, when it was raised from 56.25 cents to 57.5 cents, an increase of 2.2%. Like Enterprise Product Partners, Plains All American raised its distribution every quarter last year and twice so far this year.

The partnership has returned 49.8% over the past twelve months. The analysts’ 5-year annual earnings growth estimate is 26.2%, the company’s PE is 18.3 and its dividend-payout ratio is 70%.

Plains All American is actually scoring higher now than it has the last couple of times that I checked – in the past it has scored 17, but today it scores a 19, which would be enough to qualify for my portfolio, if I were still looking to add companies.

I’ve prepared a chart to show how these three MLPs score:

 

Years

Yield

DGR

EGR

Payout

Total Return

PE

TOTAL

                 

EPD

3

4

1

3

2

2

4

19

SXL

1

3

4

4

1

4

3

20

PAA

2

3

1

4

3

4

2

19

Summary

If you’re over 70, you have little discretion in how much to withdraw from your IRA or 401(k) – you can choose how MUCH to withdraw, but not how LITTLE. The federal government has already made that decision for you, based on your projected life expectancy and the balance of your portfolio.

However, if you find that you are forced to withdraw more than you actually want or need to spend each year, you do have some pretty good options about what you can do with the “extra” money.

Consider opening a taxable account and purchasing tax-deferred Master Limited Partnerships, particularly the three I have outlined in this article. They will provide excellent tax-deferred income and also offer the potential for impressive share-price growth.

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Karin Hernandez is long Enterprise Product Partners and Sunoco Logistics Partners. The Motley Fool recommends Enterprise Products Partners L.P.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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