Executive Summary
Given the costs associated with investment advice, clients often want to maximize any available tax benefits to help mitigate the cost. Fortunately, the IRS does allow a tax deduction for certain investment-related expenses, and while the treatment isn't ideal - a miscellaneous itemized deduction subject to the 2%-of-AGI floor, and an AMT adjustment - something is better than nothing. In fact, the IRS even allows investment advisory fees to be deducted when paid on behalf of retirement accounts like IRAs and 401(k) plans. Alternatively, the IRS also allows investment advisory fees to be paid directly from a retirement account - which effectively allows the fee to be paid with 100% pre-tax dollars.
However, an important caveat is that while retirement accounts can cover their own fees, paying any other fees from such accounts can trigger highly adverse results, including taxable distributions, early withdrawal fees, and even a prohibited transaction disqualification of the entire retirement accounts! In the end, the power of tax deferral means that most clients will probably simply pay fees from taxable accounts and claim whatever tax deduction they can, but clients with shorter time horizons - including and especially retirees - should consider paying fees directly from their IRAs and other retirement accounts... but be certain those fees are only for the associated retirement accounts!
(Michael's Note: The Tax Cuts and Jobs Act of 2017 altered the rules for deducting investment management fees from taxable accounts. See here for more recent information on the tax treatment of advisory fees after TCJA.)
Deducting Section 212 Expenses
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 Management Fees And IRA 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 are 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 Brokerage Fees And 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 Investment Fees From An IRA 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!
And either way, though, it will always be preferable to use "outside" dollars to pay the investment management fee for a Roth IRA, as even if the fee isn't deductible, it's better to pay with after-tax dollars from a taxable account than using future-tax-free-growth dollars from the Roth IRA itself!
(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.)
I am curious how this applies to financial planners that charge a flat fee, or base the fee on net worth instead of AUM?
If Investment Mangement fees are not tax-deductible for tax-exempt investments like municipal bonds, how do you break this down? Does the client need to do a pro-rata calcuation for how much of their portfolio is in munis?
Since Roth IRAs do not produce taxable income, is it implied that fees attributable to Roth cannot be deducted?
Michael,
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?
I wonder how many IRA custodians can administer the payment of these fees. Are we asking them to issue a check to the asset management provider? Can we trust them to not issue a 1099 for the distribution? Has anyone done this and can comment on the experience?
I’ve always been curious how these rules apply when you have two IRAs, specifically a Roth IRA and a traditional IRA. Is it possible to take investment management fees for both accounts out of one IRA or the other (like paying the Roth IRA fee out of the traditional IRA)?
I have the same question, Mike what is your opinion about the payment of a taxpayer’s Roth IRA fee from that same taxpayer’s Traditional IRA? If it is not allowed, what would the difference be if you were initially going to charge the Roth and Trad IRA 1%/yr management fee, then instead charged the Trad IRA 2% and the Roth IRA 0% (assuming the same balance, etc) – you would get to the same exact tax standpoint but not technically charged the Roth IRA fee against the Traditional IRA…
A second related question is, if the Traditional IRA custodian doesn’t send out a 1099 for the amount of the fees charged, how will the IRS find out that a prohibited transaction has even taken place?
Were you able to arrive at a conclusion RE: whether this is permissible?
So what’s the answer – can you take the advisory fee for both accounts (Roth & Trad. IRA owned by same person) in total from the Trad. IRA?
I was told by a no load Variable Annuity Company that charging a fee in a non qualified VA is not allowed. Then they restated their position that the fee would be considered a premature distribution if under the age of 59 1/2. Why would fees be allowed in qualified accounts such as IRA’s and SEP’s, but not in a NQ VA, which is also treated as a retirement account for tax purposes (age 59 1/2, tax deferred, etc)?
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
Gary,
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.
– Michael
I have been wondering about the definition, specifically of NET INVESTMENT INCOME as it pertains to the new 3.8% proposed medicare surcharge and tax increase.
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 !
Thx
Pam,
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!
– Michael
Thank you Michael. I enjoy your blog and measured, informed vision. I just sat for the CFP exam, wish me luck !! Pam
Michael,
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
Thanks, Mike.
For the past 2 years, I wrote a check to my advisor to manage both my taxable and IRA accounts. It seems i would have been better off paying him at least part from the IRA. I had no benefit in either year becasue of the 2% threshold. Could I pay him this years fee mostly out of the IRA to “catch” up on the old allocations or am i just out of taking advantage of this on the past 2 years.
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?
Another consideration is the likelihood of an IRS notice questioning the difference in gross an taxable. There are several reasons for a difference including tax basis and in recent years direct charitable donations. If the get and accept enough legit responses perhaps the notices will lessen. I know of advisers and clients who have opted out because of the fairly common IRS notices.
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.
Harry,
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?
– Michael
Mike, is my situation really unique?
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.
Hi Mike,
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.
Mike,
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?
Cheryl,
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.)
– Michael
I just got off a chat with a CPA at TurboTax who sent me a link to your article that I read with great interest. TT confirmed that we (my wife and I have separate accounts) could deduct our 401k management fees, subject to the 2% AGI limit and we did pay them out-of-pocket. But you article raised maybe a more important question/concern. To save on cash flow, we started in 4Q2012 to deduct our 401k fees from an IRA account being managed by the same company as our 401k’s. While all three accounts are basically retirement accounts, it sounds from reading your article, that this may not be the wisest thing to do. True?
What a fascinating discussion! I think that Harry’s situation is one in which the client is simply paying the fee with taxable income because the custodian ( presumably V) doesn’t recognize the fee as being paid to an RIA. If they dont have the institutional platform, then they usually do not deduct fees.
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.
Patricia,
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.
– Michael
Michael,
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.
Michael-
Thank you for the information you are sharing. I have several qualified inherited ira trusts that I am the trustee. The RMD’s come into the trust and then flow to the beneficiaries, so the trusts do not owe taxes, but file returns. My question is– can the custodial management fees and any 990t return preparation fees be deducted on the trust return to reduce the k1 amount that flows out of the trust to the ira/trust beneficiary. I appreciate your insight.
Thanks,
Don
Michael: We have a client for whom we did a 1035 exchange from a Pru NQ annuity to Jeff. Nat’l NQ annuity. He is over 60. He received a 1099 r apparently generated from our fee deducted directly from the new account. He never received 1099’s during all the years at Pru, Is this routine? What are his alternatives if any under IRS treatment?
He paid higher expenses through the share class at Pru. These won’t generate 1099 because there is no direct withdrawal. Your fee deduction as a RIA from NQ Annuity will always generate 1099. So you can either bill him through the Jefferson National Annuity or through another investment account.
Don’t forget that medical and dental expenses also fall under the miscellaneous category, so total those along with your investment expenses. See the end of this article: http://www.nolo.com/legal-encyclopedia/deduct-your-investment-expenses.html
Can you aggregate and pay Roth management fees from a traditional IRA without tax consequences?
How about this article?
http://www.bankrate.com/finance/taxes/are-investment-fees-tax-deductible.aspx
Certain IRA administrative fees, whether or not you’re currently taking distributions, are deductible, but they have to be paid by the account owner’s non-IRA funds. You’re right that investment fees paid to produce taxable income are tax-deductible. These expenses are miscellaneous itemized deductions subject to an overall reduction of 2 percent of adjusted gross income.
Read more: http://www.bankrate.com/finance/taxes/are-investment-fees-tax-deductible.aspx#ixzz45jDx3E1p
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Mike:
Mike:
Are fees paid out of an IRA to prepare Form 990T forms treated as a distribution to the IRA owner?Thank you.
I know that you can deduct advisory fees from an IRA. Can you deduct commissions paid on an IRA account?
Advisory fees paid from an IRA are “deducted” from the account. They CANNOT be deducted on the tax return when paid from the IRA, though.
Commissions paid on an investment bought within an IRA will already be reflected in the price/value of the investment in the IRA. In this manner, they are similarly “deducted” from the value of the account. But also like an advisory fee, they CANNOT be deducted on the tax return.
– Michael
If I may flog this dead horse, Is it true that once you’re subject to RMDs, this is simpler? My RMDs are taken monthly from the IRA, deposited in a taxable account, and appear it total on a 1099. Advisor fees are withdrawn from the same taxable account, and are thus deductible. If the fees were deducted from the IRA directly, however, they would not be deductible – correct?
Phoebe,
These are completely unrelated.
If you have an RMD, take an RMD.
If you want to pay your advisory fees from your taxable account, pay from your taxable account.
The fact that the money IN your taxable account might have gotten there FROM an RMD is irrelevant. Take the RMD because you have to, pay from the taxable account if you choose to. They’re unrelated.
As noted here, if advisory fees are taken directly from an IRA, they are not deductible (as the account was already pre-tax by definition). However, you would still need to take your RMD as well. Because, again, RMDs and advisory fees are completely unrelated. 🙂
Hope that helps!
– Michael
Thanks; the reason for wanting the fees to be deductible, is that deduction is a big contribution to itemized deductions, making them exceed the standard deduction.
If a client has two IRAs, can both advisor fees be taken from one IRA? I didn’t see this clarified in the conversation. Thanks.
Can investment management fees related to other retirement accounts (such as a 403(b) account) be deducted from an IRA account, similar to how retirement distributions can be lumped together and taken from just one retirement account?