Are Investment Management Fees Tax Deductible?

with 2 Comments

Are Investment Management Fees Tax Deductible?

I often get asked, “Are investment management fees tax deductible?” The answer is not a simple “yes” or “no.” Like many tax questions, the answer is “It depends.”

Investment management fees are a tax-deductible expense. They can be listed on Schedule A under the section “Job Expenses and Certain Miscellaneous Deductions.” Line 23 includes investment expenses. These expenses get added into unreimbursed employee expenses, tax preparation fees, safe deposit boxes and other qualifying expenses.

Unreimbursed employee expenses can include professional dues, required uniforms, subscriptions to professional journals, safety equipment, tools and supplies. They may also include the business use of part of your home and certain educational expenses.

All of these miscellaneous deductions are totaled. You only receive a tax deduction for the amount that exceeds 2% of your adjusted gross income (AGI) from line 38 of your Form 1040. If your cumulative expenses are under 2% of AGI, you will not get a deduction.

For most of our working clients, their miscellaneous deductions fall far short of the 2% AGI threshold. But when clients retire, they are much more likely to qualify.

If your expenses are close, you gain from lumping most of your expenses every other year. For example, if your AGI is $100,000 and your miscellaneous expenses average $2,500 a year, in most years you will only get a $500 deduction. But if you can pay the same bills in January and December of one year, you might be able to have $5,000 in deductions one year and zero the next. That means you could have a $3,000 deduction every other year. In next year’s 28% tax bracket, this would save you $560 more in taxes.

Even if you can’t deduct investment management fees directly, you can still pay a portion of the fee with pretax dollars. Investment management fees can be deducted directly from the accounts for which they were charged.

Many fee-only advisors charge a percentage of assets under management. But they can also prorate those fees back to the accounts they are managing. For traditional IRA accounts, the fee is not considered a withdrawal and therefore is not a taxable event. The fee is considered an investment expense. Thus this fee is being paid with pretax dollars. And the cost is discounted to clients by their marginal tax rate.

I’ve seen advisors take their entire management fee from IRA accounts. I don’t think that is warranted by the letter or the spirit of the tax code. Any fee taken from an IRA account should be justified as a fee for the management of a pretax account. You can’t simply start paying your bills from an IRA as a nontaxable withdrawal.

Similarly, any management fees paid directly from an IRA account should not be listed as a miscellaneous expense on Schedule A trying to qualify for an additional tax deduction. Only expenses paid from a taxable account should be listed as a miscellaneous expense.

There is no advantage in trying to pay the entire fee from a taxable account in an attempt to boost your deductions. If you pay $2,500 in management fees, it is better to pay $1,000 from an IRA with pretax dollars than to pay for it separately to get a $500 tax deduction. Any amount paid from an IRA is equivalent to getting that same amount as a tax deduction.

Although getting money out of a traditional IRA tax free is an advantage, taking management fees out of a Roth IRA is not. There are limits on getting money into a Roth account where it will never be taxed again. We recommend paying the portion of management fees prorated to a Roth account out of your taxable account. This allows as much money as possible to stay in your Roth.

One of the advantages of working with a fee-only financial planner is that fees can be taken from the accounts under management or paid separately, depending on which is more advantageous. If fees are stuck on commission-based products, you can’t choose to pay the fees for a Roth account separately from a taxable account in order to allow the Roth to grow unimpeded.

This is another advantage to having fees based on assets under management rather than a separate fee or an hourly charge. Management fees are easily justified taken directly from accounts including IRA accounts where you can pay with pretax dollars.

Many advisors charge a percentage of assets under management and then offer comprehensive wealth management advice without an hourly charge. This is ideal. If these charges were separated, less of the fee could be paid with pretax dollars.

No one likes to pay fees. Hidden fees in many ways are easier psychologically. We recommend that when you need unbiased financial advice, seeking a fee-only financial planner makes sense. And it helps knowing there are tax-efficient ways to pay management fees.

Visit the National Association of Personal Financial Advisors (www.napfa.org) to find a fee-only advisor in your area.

Follow David John Marotta:

President

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818…)

2 Responses

  1. Mark Prendergast
    |

    David: a nice synposis. I would add a couple of other items. While I agree with your approach on NOT paying IRA fees with non-IRA funds, there is the argument that once Taxpayer crosses the 2% AGI thresshold, s/he has more working on a tax-deferred basis, hence some benefit of compounding. Still I don’t like it [again, I’m in your camp] for two other reasons: [a] the prevelence AMT: when the client is subject to AMT, the “investment expenses” become nondeductible just like other Misc Itemized Deductions; and [b] if they’ve been paying IRA fees from non-IRA funds, the IRA account will be higher, and RMDs will be higher. The alternative to [b] is that they have more nonqualified assets and less IRA assets. Which leads me to the Tax Diversification discussion.

    There have been recent discussions on “tax diversification” and “asset location”. Those who pay their IRA fees from non-IRA funds tend to be over-allocated on the IRA side. [That’s my observation, and certainly not statistically validated!] I think we all have clients who have nearly 100% of their assets in qualified accounts, and we see the hamstring effect that every withdrawal being subject to Uncle Sam’s lien [i.e., tax].

    Lastly, I’ve wondered but never researched the propriety of deducting the Roth fees from a Traditional IRA account. Seems that it would be against public policy and it might be construed as a taxable distribution from the Traditional IRA. If that were the case, then it would make sense to pay the Roth fees from non-IRA accounts. I’d be curious if anyone knows definitely, like has the Treasury Department ruled on the subject?

    • David John Marotta
      |

      Greetings Mark Prendergast,

      Regarding your last question, only those management fees associated with pretax accounts may be deducted from a pretax account. Hence taking the fee for a Roth IRA from a traditional IRA is not allowed. Taking any fee from a taxable account is always allowed.

      Regarding your first comment, once a taxpayer has crossed the 2% AGI threshold either method of paying the fee is usually equivalent, but as you suggest there are cases when taking the fee from the pre-tax account avoids potential tax code interaction and therefore is always safe for the equivalent of a deduction.

      Thanks for your comments!