Wednesday, November 14. 2012
Section 212 of the Internal Revenue Code - entitled "Expenses for the Production of Income" - details the deductibility of expenses associated with an individual's money and financial issues. Under Section 212, there are three categories of deductible costs, including: "all the ordinary and necessary expenses paid or incurred during the taxable year:
- for the production or collection of income;
- for the management, conservation, or maintenance of property held for the production of income; or
- in connection with the determination, collection, or refund of any tax."
Notably, there is a requirement for the fee to be deductible to be attributable to income, which the IRS has interpreted to mean taxable income; as a result, investment management fees for tax-exempt investments like municipal bonds are not deductible. Traditional investment advisory fees, though, including ongoing AUM and wrap fees, generally are deductible as long as they're not directly attributable to the management of tax-exempt assets.
Unfortunately, though, the fees must be claimed as a miscellaneous itemized deduction, which means the fees are limited to a 2%-of-AGI floor, and also are an AMT adjustment and consequently non-deductible for AMT taxpayers. Although some taxpayers in the past have tried to avoid this adverse result by capitalizing the fees instead (i.e., adding them to the cost basis of the security, similar to a transaction fee), the IRS has ruled that this is not permissible treatment; for better or for worse, clients have to claim the fee as best they can and enjoy whatever deduction they do, or don't, receive in the end.
Investment Fees And Retirement Accounts
While the treatment of investment advisory fees is relatively straightforward when paid for/from a taxable account - the fee is deductible in the year paid as a Section 212 expense, and the client will or will not get some tax benefit from that after claiming it as a miscellaneous itemized deduction subject to the 2%-of-AGI floor - the matter is somewhat more complicated when retirement accounts are involved.
The first question that arises is simply whether an investment management fee can be deducted when paid on behalf of IRA assets, given that IRAs are tax-deferred and do not create ongoing income in the first place. Fortunately, this issue has been addressed, most recently in PLR 201104061 (discussed previously on this blog), which affirmed that "wrap fee"-style arrangements like ongoing AUM and investment advisory fees can be paid with outside taxable dollars and still deducted as a Section 212 expense (a position the IRS continues to support since PLR 8830061). In previous rulings (PLRs 9005010 and 200507021), the IRS also confirmed that paying fees on behalf of an IRA will not be treated as a constructive contribution to the account (which might have otherwise exceeded annual contribution limits).
Because investment advisory fees are Section 212 expenses, this also means that a retirement account's ongoing investment advisory fee can be paid directly from the account without being treated as a taxable distribution, under Treasury Regulation 1.404(a)-3(d). However, since the fee is being paid directly with retirement account dollars and not the taxpayer's own money, it will not be personally deductible to the account owner (of course, if the retirement account is pre-tax, then by definition the entire fee would have been paid with pre-tax dollars already, so there would be no need for a tax deduction!).
Thus, in essence, the retirement account owner has a choice to pay investment advisory fees with the money in a retirement account - which is subtracted directly from the account without tax consequences - or to pay the fee with outside dollars instead, and claim the itemized deduction.
Criss-Crossing Fees From Retirement Accounts
Notably, while the rules do allow taxable accounts to pay retirement account fees, or for retirement accounts to pay their own fees, it is not permissible to have a retirement account pay for fees attributable to a taxable account (or other investments), because such expenses would not be "ordinary and necessary expenses of the retirement account" in the first place. Instead, a payment from a retirement account for the fees of other accounts would be treated as a taxable distribution (with potential early withdrawal penalties due as well), in the same manner that using a retirement account to pay any other personal bills and expenses would be treated as a distribution.
Unfortunately, though, the potential treatment from retirement accounts is even more severe, because of the so-called "prohibited transaction" rules under Section 4975, which stipulate that when a retirement account conducts a transaction between an account and a "disqualified person" (which includes the account owner and his/her family), the transaction can be subject to a penalty tax of up to 100%(!) of the amount and the entire account can be disqualified (i.e., treated as though the entire account has been fully distributed for tax purposes).
As a result of the prohibited transaction treatment in particular, it's absolutely crucial not to have a retirement account pay someone's personal bills or engage in inappropriate transactions - which includes not allowing your retirement accounts to pay investment advisory fees for your personal, non-retirement accounts!
Notably, these restrictions on payments from retirement accounts also mean the retirement account should not pay other personal financial fees and expenses as well, including financial planning fees. Thus far, however, the IRS has been somewhat lenient in allowing a bundled fee that includes investment advisory fees and some other 'minimal' expenses (like financial planning services) to still qualify; nonetheless, advisors should be cautious about trying to bundle too many other fees and expenses into a single comprehensive "investment advisory" fee, if the fee is going to be paid from retirement accounts.
Is It A Good Deal To Pay From Retirement Accounts When Permissible?
Given that investment advisory fees can be paid from retirement accounts - as long as the fee is attributable only to the retirement account - the question remains whether a client should pay from retirement accounts when it is possible to do so.
The real answer is that "it depends" - specifically, on whether or how much of the fee would have been deductible if it was simply paid with outside dollars instead. After all, the primary benefit to paying a fee from a retirement account is the ability to pay it with pre-tax dollars - since by definition the retirement account is pre-tax. If the fee would have been fully deductible if paid with outside dollars anyway, then it's best to simply pay with outside dollars, and allow the IRA to maximize its ongoing tax-deferred growth.
However, in practice an investment advisory fee is often not fully deductible for clients, in part due to the 2%-of-AGI floor on miscellaneous itemized deductions, but more commonly because it is an AMT adjustment and consequently most or all of the deduction is lost as clients cross into AMT exposure. In such scenarios, the decision represents a trade-off - the upside to paying with outside dollars is allowing the retirement account to compound, and the upside to paying with retirement dollars is making the entire payment on a pre-tax basis. Mathematically, the power of tax-deferred compounding can eventually beat the benefit of the tax deduction (even if none of the payment is tax deductible when paid with outside dollars), but it can take anywhere from 20-40 years, depending on tax rate and growth rate assumptions.
In the end, this means that for clients with very long time horizons - or where the fee actually will be partially or fully deductible - it's best to pay with outside dollars. However, for clients where the fee is not deductible, and the time horizon is shorter - e.g., for current retirees - the best deal may be to simply deduct the fee directly from the retirement account and get the full pre-tax value. In such scenarios, though, it's still important to ensure that the retirement account is only paying the fees attributable to itself, to avoid the highly adverse taxable distribution and prohibited transaction consequences!
(This article was featured in the Carnival of Personal Finance #388 on Sweating the Big Stuff, the Carnival of Retirement 47th edition, Nerdy Finance #17 on NerdWallet, and also Carnival of Money Pros on Vane$$a's Money.)
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Ostensibly, if the fee is otherwise disassociated from assets and investment management, an itemization/allocation of the fee would need to be made to determine how much of it was attributable to investment management (deductible) or tax planning (deductible) and how much was attributable to general financial planning (sadly, not deductible).
There's no particular guidance existing for this, but if the fee was clearly disproportionate to the assets such that it couldn't reasonably be substantiated as an investment management fee, then some allocation or determination of partial deductibility should occur.
Yes, a calculation needs to be made to allocate the expenses to deductible and non-deductible portions, as investment management expenses for municipal bonds are not deductible.
In general, the expenses are usually allocated either by a percentage of assets (if 5% of the portfolio is munis, 5% of the expenses are carved out) or as a percentage of income (if 5% if the total interest income earned was munis, 5% of the expenses are carved out). Obviously, the latter may be a problematic method in a multi-asset-class account where income may be distorted by equities that don't necessarily produce income, so most multi-asset-class portfolios lean towards the former, not the latter, as a methodology.
To my knowledge there has never been a directly on-point ruling for this issue, and it's still a bit of a grey area.
Treasury Regulation 1.212-1 states that an expense is deductible if "It has been paid or incurred by the taxpayer during the taxable year (i) for the production or collection of income which, if and when realized, will be required to be included in income for Federal income tax purposes..." Thus why the fee is still deductible for unrealized capital gains (will be taxable when sold) and for traditional IRAs (will ultimately be taxable in the future).
The question mark for Roth IRAs is that they're not ALWAYS tax-free. They're only tax-free if the distribution is a qualified distribution. Granted, most people invest and hold Roth IRAs with the intent of making tax-free withdrawals, but it's not necessarily a guaranteed fact.
Accordingly, I still see some people trying to deduct investment management fees for Roth IRAs (assuming it's paid with outside dollars), but it's uncertain at best. Clearly, the more conservative treatment would simply be to not deduct fees allocable to Roth IRAs.
I hope that helps a little!
Non-deductible contributions don't create an issue for IRAs. The GROWTH on IRAs is all taxable, which is what enables the deductibility of fees paid to manage it.
If management fees weren't deductible for cost basis, you wouldn't be able to deduct fees for anything you buy, because on the day you buy it the entire position is after-tax cost basis!
Deductibility is based on the GROWTH being taxable, not the principal. That's why it works for normal stocks, and works for IRAs regardless of whether the principal contribution was pre-tax or after-tax.
I hope that helps a little!
Thanks for the detailed description of these rules. I wonder if you or any of your readers can cite rulings or court cases where the consequences of taxable distributions or prohibited transactions were enforced. Also, are there examples of IRS notices to an advisor that warn the advisor to become compliant with the rules?
The client is 59 and plans to begin taking distributions in May when he is 59 1/2. It would seem based on your post above, that the short time horizon would make taking the fee from the account desirable
The annuity company's comments are correct, at least as the tax law is currently written and interpreted.
The reason for the difference is simply that the Treasury has issued Regulations and the IRS had put forth guidance to allow it for IRAs, but have not done so for annuities. And short of some administrative grace from the IRS or Treasury, paying fees directly from an annuity would be treated as a distribution, because that's how Congress wrote the rules.
As it stands right now, the only way an advisor can be paid for an annuity directly from the company and the contract's value is if the advisor is an agent or employee of the company (which is why brokers can be paid trails), because that's deemed to come from the expense ratio of the contract, not as a constructive distribution from the annuity.
Not the most appealing answer or results, but that's the way the rules are written at this point.
The Tax applies - as far as I can tell - to the "lesser of Net Investment Income" or "Modified AGI - $200/250,000". MAGI does not include munis or Roth distributions.
Does Net Investment Income then allow for the deduction of both margin interest ( specific to income) AND investment management fees, per the above discussion? That would be nice !
Under IRC Section 1411(c)(1)(B), net investment income can be reduced by any deductions properly allocable to your investment income.
So yes, both margin interest and investment management expenses should be deductions that reduce net investment income for the purposes of the 3.8% Medicare tax.
Of course, that's separate from determining whether those amounts will be deductible on Schedule A for regular tax purposes.
I hope that helps a little!
I think I know what you will say, but here goes.
Is it ok to take 100% of my fee from the IRA, and then have the client pay taxes on the (say) 25% that is pro rated to the client's non ira account? The 25% goes on sch A, where it serves no purpose.
I use the same approach when there is a ROTH
Does the fact that he didn't know or suggest i pay his an allocable portion of his fee from the IRA send a red flag up that i should consider changing financial advisors?
Unfortunately, you can't make IRA payments for prior years to "catch up" at this point - to be permissible, fees should be allocable to the current period.
In terms of whether this is a red flag for an advisor, I would say probably not. Sadly, this is an area where there's a lot of confusion amongst advisors as well about whether paying from the IRA is best - the purpose of this article was actually to educate advisors for that very reason.
You could always direct him this way to read it and reconsider for the future at least?
Mike, if you can, see my question at #9 above.
I take it you can't pay outside the IRA and then reduce the 1099R amount.
And concerning the issue of a prohibited transaction. If a tax payer pays tax on the distribution, why would it be prohibited? An IRA owner can take a distribution, pay the tax, and do whatever he or she wants with the money.
The transaction is at risk for being prohibited when someone does NOT report it as a distribution. That's the whole point. If it's a distribution, it's taxable. If you claim it's NOT a distribution, and you use IRA dollars for personal uses, then it has to be a prohibited transaction.
Regarding your prior question, I have trouble understanding what you want to do. It sounds like you want to bill an IRA for a fee - say $10,000 - even though the permissible fee was only $7,500, and cover for this by reporting the last $2,500 as taxable and then trying to take an offsetting $2,500 itemized deduction as a miscellaneous itemized deduction on Schedule A.
Yes, technically that is accurate on the tax return, although you're going to make it almost impossible for the custodian to know how to issue a proper 1099-R, and you'll also have early withdrawal penalties on the $2,500 if the client is not age 59 1/2.
Assuming you can navigate all of the above, I guess you "could" do this, but I don't know why on earth you would. There's no advantage to doing so, and it begs to at least be investigated in an audit; even if the results are ultimately upheld, it's hard to see why it's worthwhile to invite the audit risk and confusion when there's no benefit to doing so?
I manage money for clients, some is in tax deferred accounts, some isn't.
Some clients prefer I take my fee from their IRA, some from their taxable account.
It makes sense to me that the portion attributable to the IRA can be offset against the 1099, whereas the other goes to Schedule A. If an item belongs on schedule A, I put it on schedule A. I don't ask is this going to be a deduction? I put it there and then I find out. Maybe the client has union dues, or a very expensive safe deposit box. Generally they get a piece of it, and anything is better than nothing.
If the custodian would adjust the 1099R accordingly, we wouldn't be having this discussion. Or maybe I don't know what you mean by a "proper 1099". And, of course, you don't take from the IRA, if it's going to get the 10% penalty. I wouldn't have many clients if I recommended that. The invitation to an audit that I see is showing the taxable to be less than the gross 1099R? But I thought that was the whole idea.
If your client wants to take a taxable distribution from an IRA, put it in a brokerage account, and then pay your fee with the distribution, you can certainly do so.
But fee-sweeping from an IRA for expenses that don't pertain to an IRA is inviting trouble. The IRA custodian doesn't necessarily have any idea that your fee sweep is for an "outside" fee, so they have no possible way to know how to issue the 1099.
Best practice - and frankly, standard practice as far as any custodian I've ever talked to - is that you either bill EVERYTHING from the taxable account (and report on Schedule A), or you deduct the IRA's fee from the IRA and the brokerage account's fee from the brokerage account (and report the brokerage fee sweep from Schedule A).
We don't bill our IRAs for our groceries or our mortgage (which are expenses that don't pertain directly to the IRA itself), and shouldn't be billing the IRA for non-IRA fees either for the same reason. Yes, I suppose you conceivably "could" as long as you turn out to report it correctly, but it's inviting a disaster. If you ever, once, for a dollar, fail to report it properly, it's technically a prohibited transaction and invalidates the ENTIRE IRA. Why play with fire, when it literally provides NO benefits anyway over just billing the IRA for the IRA fees and the brokerage account for the brokerage fees?
I'm going to review your blog all over again.
I thought it applied to my situation, but maybe it doesn't.
Until July 2003, a custodian deducted my fee from my clients account, and if it was an IRA, there was no 1099R. It was my responsibility not to mix the IRA fee with a non IRA fee.
In 2003 the custodian shut down the custodial service. (10 years already, wow, I remember it like it was yesterday)I resisted urging to move the clients to a brokerage service elsewhere. Instead from that point on I have operated through what is generally referred to as a retail platform. Under retail, when a withdrawal is made from an IRA they issue a 1099R. It doesn't matter what the withdrawal was for. From that point on I put the fee on schedule A.
In the last year or so, I read a couple of articles (one in WSJ) about netting on the tax return. I thought your blog was on that subject.
Overall the principal is the same. Pay taxes on distributions with the exception of those applicable to appropriate IRA related expenses.
If the reality is that 100% of every fee being swept from the IRA is being reported on a 1099-R, then your problem is the opposite direction - the distribution is being OVER-reported. Fees directly attributable to the IRA should NOT be on the 1099-R - they are permissible (pre-tax) expenses of the IRA, which is a far better treatment than just claiming all of the 1099-R amount on Schedule A.
We did a non-qualified 1035 exchange into a variable annuity. Based upon what I am reading, it seems that since the m&e fees are deducted from within the account, they cannot be claimed as a miscellaneous deduction. Is this a correct interpretation? I assume there is also no basis to argue that the initial sales fee charged to get into the annuity is deductible since it was taken out of the initial deposit?
You are correct that M&E fees paid directly from the cash value of a variable annuity cannot be deducted.
However, the reality is that because they reduce the account value, by default they are already being applied against any current/future pre-tax growth in the annuity. So aside from the timing - you'll get the value of the deduction upon surrender, and not immediately - you're actually getting the full value of paying 100% of those fees with pre-tax dollars. (Although the results are somewhat more restricted if this results in a net loss at the time of surrender, due to the relatively unfavorable loss treatment on variable annuities.)
Indeed, I'm afraid it's not appropriate to have 401(k) fees deducted from an IRA. They can be paid from the 401(k) directly (which would be pre-tax by virtue of the account), or paid with outside dollars and deducted as a miscellaneous itemized deduction subject to the 2%-of-AGI floor.
But the IRA should only pay fees attributable to itself. You can aggregate multiple IRAs for this purpose and pay one fee to cover several of them, but IRAs only aggregate with each other, not with 401(k)s. It may seem silly given the similarity in the types of accounts, but that's simply how they wrote the rules.
Thanks for your quick response. To avoid potential future IRS issues with this, can and should I "repay" my IRA for the 401k fees deducted from it?
I was wondering if you might elaborate on your response to Paul (#14) If you aggregate IRAs and take the fee from just one of them, the IRAs must be in the same name, not just on the same tax form. Namely, you cannot aggregate a husband and wife's IRA and then take the fee from just one. That is my understanding and I hope that it has been correct.
You are correct regarding aggregation - it's only an individual PERSON's IRAs. The IRA of a husband and wife do not aggregate, nor do the IRAs of an individual and decedent beneficiary IRAs for his/her benefit.
The aggregation rule still only applies to one individual's own personal IRAs - traditional/contributory, rollover, SIMPLE, SEP, etc., but that's it.
Thank you VERY much for your help.
I will call my IRA financial adviser in the morning, about this subject.
I am now 70 years old and will start IRA withdrawls this year.
This is what I plan to do:
1. Have her invoice me for her management fees, and I will pay it from other funds. Can I ask her to include the first payment that was already deducted from the IRA?
2. I plan to aggregate the required withdrawls and withdraw all from a different IRA.
3. Can I deduct her fees as miscellaneous itemized deduction subject to the 2%-of-AGI floor, when taxable income is mostly the IRA withdrawl and SS? What if it was only SS, as in past years?
4. Can I deduct my subscription to Investors Business Daily. I use it to manage two IRAs and a much smaller taxable account.
5. Can I deduct the annual subscription to AIQ TA software that includes data downloads, that I use daily?
I see tax benefits of deducting her fees now, instead 20 years from now when I take the last withdrawls.
Fees and withdrawals left in, will compound to higher balances into the future.
On a different subject:
Will tax-deferred withdrawals ever be excluded from the SS worksheet?
THAT is causing these funds to be taxed twice, totaling 46.25% for millions of people. It isn't fair.
Thanks for your response.