Ways to Pay Investment Advisory Fees | Rodgers & Associates

Under TCJA, can Investment Advisory Fees Still have a Tax Benefit?

Many taxpayers have filed their returns for 2017 and are grateful tax season is behind them. Tax planning for 2018 is probably one of the last things they want to think about. However, the Tax Cuts and Jobs Act of 2017 (TCJA) made changes to the tax code starting in 2018. Some changes will require acting now to make the most of the new law.

What TCJA Repealed

TCJA repealed all miscel­la­neous deduc­tions, which included unreim­bursed business expenses, tax prepa­ration fees, union dues, and investment advisory expenses. The deduction of advisory expenses was not lucrative for many taxpayers. Under the tax code section 212, the deduction was allowed for ordinary and necessary expenses paid during the year in connection with one of the following:

  • production or collection of income;
  • management, conser­vation, or mainte­nance of property held to produce income; or
  • deter­mi­nation, collection, or refund of any tax.

Fees for financial advice that did not pertain to one of these three categories were not deductible. Fees and expenses were only deductible if they were used to produce taxable income. Fees paid to manage tax-exempt bonds, or a Roth IRA would not be deductible. Fees would also not be deductible if they were paid using IRA assets. Only fees and expenses paid from a taxable account that held taxable-income producing assets were tax deductible.

The total amount of eligible deductible fees and expenses could not be used to reduce income like chari­table contri­bu­tions or mortgage interest. The combined amount of investment advisory fees and expenses, plus any other miscel­la­neous deduc­tions, had to exceed 2% of adjusted gross income (AGI) before they could be deducted from income. This benefit could be reduced even further if the taxpayer was subject to the alter­native minimum tax (AMT).

Ways to Pay Investment Advisory Fees

The repeal of the miscel­la­neous deduction is not signif­icant to some upper income taxpayers. Those taxpayers who did exceed the AGI threshold and did not fall victim to the AMT, did experience a tax savings if they paid these expenses from a taxable account. Now that TCJA elimi­nated this deduction, is there anything that can be done to recapture this tax benefit?

From your taxable account

Fees paid from a taxable account are no longer deductible. However, some advisory firms allow investors to pay the portion of the fee used to manage their IRA assets directly from their IRA. Treasury Regulation 1.404(a)-3(d) says that a retirement account’s ongoing investment advisory fee can be paid directly from the account without being treated as a taxable distri­b­ution. Assuming the retirement account is all pre-tax dollars, the entire fee will be paid with pre-tax dollars, which is effec­tively the same as a tax deduction. One could argue it is better than a tax deduction under the old rules because 100% of the fee was never deductible because of the 2% AGI limitation.

Some advisers would argue that investors should still pay fees and expenses from a taxable account even though they can no longer deduct the fee. There could be more value in leaving the funds inside the IRA to keep growing on a tax-deferred basis. Compounding the growth of these funds over years could grow to a signif­icant amount.

One should take into consid­er­ation that fees paid from a taxable account would reduce the value of that account as well. Those funds would continue to grow although in a taxable account. However, they could be invested in assets that are taxed at a lower rate, such as long-term capital gains or qualified dividends. Funds that grow in an IRA will eventually be taxed when they are withdrawn from the account. However, IRA withdrawals are taxed as ordinary income. Ordinary income is currently taxed at a higher rate than long-term capital gains.

With pre-tax dollars

There is also the immediate benefit of paying the fee this year with pre-tax dollars versus waiting for a potential benefit in the future. I would love to be able to pay my accountant and attorney bills out of my IRA with pre-tax dollars. Unfor­tu­nately, that is not allowed. Allowing the IRA to pay its own fees also reduces the balance in the account, which then reduces the required minimum distri­b­ution (RMD) when the taxpayer reaches age 70 ½. Retired investors who do not need their entire RMD to fund living expenses could find this to be a partic­u­larly attractive strategy.

Should you pay fees from your IRA with pre-tax dollars or from your taxable account? Investors in higher tax brackets may find using pre-tax dollars from their IRA is an attractive option. An investor in a lower tax bracket with a long-time horizon may prefer to pay the fee outside the IRA. Both investors will most likely find it is preferable to use dollars from a taxable account to pay the investment management fee for a Roth IRA, even though the fee is not deductible. It is better to pay with after-tax dollars from a taxable account than using future-tax-free-growth dollars from a Roth IRA.

Finally, if you choose to pay fees with pre-tax dollars from an IRA, make sure the retirement account is only paying the fees attrib­utable to managing the IRA account itself. Paying a fee from an IRA for expenses attributed to a taxable account or a Roth IRA would be considered a taxable distri­b­ution, and could also be subject to early withdrawal penalties.

Rick’s Tips:

  • TCJA repealed all miscel­la­neous deduc­tions which included the deduction for investment advisory expenses.
  • Investment advisory fees and expenses were only deductible if they were used to produce taxable income.
  • Investment advisory fees can be paid directly from an IRA account without being treated as a taxable distribution.