Can You Buy Oil Royalties Through Your 401(k)?

A direct stream of oil royalties may be taxable, even in a 401(k).

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A 401(k) is an employer-sponsored retirement savings plan. Many companies offer 401(k)s as a valuable benefit, and match contributions to the plan by employees. The Internal Revenue Service sets the rules on 401(k)s and the types of investments they can hold. Your plan may have stocks, bonds, mutual funds, CDs, money market funds or cash, and may earn royalties on oil production as well. But the taxation of such income makes it a dubious investment for a retirement plan.

401(k)s and Taxes

A 401(k) account enjoys favorable tax treatment, as does an individual retirement account. Contributions to traditional IRAs and 401(k) accounts are made "pre-tax," meaning they are not included in your gross income for tax purposes. You will pay income tax on the earnings when you take distributions. If your employer offers a Roth 401(k), however, then contributions are "after-tax," but distributions are tax-free.

Oil Royalties and MLPs

There are several ways to invest in energy and oil drilling. One of the most popular is to buy the right to a stream of income ("royalties") from producing oil fields. This can be done with shares in a master limited partnership, which distributes its income and distributable cash flow to shareholders each year. The MLP itself enjoys a tax exemption on this income, while investors can defer taxes on the distributable cash flow until they sell their shares.

Retirement Accounts and UBTI Taxation

Unfortunately for retirement savers interested in MLPs, the IRS wants to discourage savers from operating partnerships or businesses through their accounts. For this reason, "unrelated business taxable income" is subject to income tax, even if held within an IRA or 401(k). Master limited partnerships fall into this category, which largely defeats the purpose of a retirement account: to provide tax advantages for your savings.

Alternative Investments

There are other ways to get oil royalty income into your 401(k). "I-Shares" mirror the structure of master limited partnerships but pay their dividends in stock, rather than cash, and they are not subject to the UBTI tax rules. In addition, exchange-traded notes and exchange-traded funds that derive their income from energy companies can be held in a 401(k). But the IRS taxes the income of companies held by ETNs and ETFs, as well as the dividends you receive as an investor, if you have a traditional 401(k). For that reason, the return may not match that of an MLP.