How to Take a Tax Deduction for Investment Management Fees

Structuring your fees differently may end up costing you less

Duduction worksheet
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Investment management fees and financial planning fees may be tax deductible. You have options as to how you structure these fees so that when viewed on an after-tax basis you end up paying less. Here’s how it works.

Taking a Tax Deduction for Financial Planning Fees

Like tax preparation fees, investment management fees and financial planning fees may be taken as a miscellaneous itemized deduction on your tax return, but only to the extent that they exceed 2% of your adjusted gross income (AGI).

 

Example: If your AGI is $100,000, and you have $3,000 of financial planning, accounting and/or investment management fees, you’ll get no deduction for the first $2,000 of fees, but you will be able to deduct the last $1,000 as that is the amount that exceeds 2% of your AGI.

Many people pay such fees with a check, using after-tax dollars, as they assume this is the best way to do it. But if you have money in an IRA there may be a better way to pay such fees so they cost you less on an after-tax basis.

Paying Fees Out of an IRA

For investment management fees or financial planning fees that are structured as a percentage of assets, you can pay fees directly out of the account managed. If it is an IRA account when you pay fees this way it is not considered a withdrawal. Instead, it is considered an investment expense and thus you are paying the fees with pre-tax dollars. For every $1,000 of fees paid this way, if you are at the 25% marginal tax rate, then on an after-tax basis it is costing you $750.

It makes sense to pay fees directly out of traditional IRAs whenever possible. However, it does not make sense to do this with Roth IRAs. Why? Roth IRA money will never be taxed so you want to let the money grow tax-free as long as possible. Traditional IRA money will be taxed one day and by paying fees out of this type of account you are avoiding paying income tax on that portion.

 

Unfortunately, you can only pay the portion of the fee attributable to that IRA out of the IRA. For example, if you have $500,000 in an IRA and $100,000 in a non-retirement account, and you pay 1% a year in fees, the $5,000 attributable to the IRA can be deducted out of the IRA, but the $1,000 attributable to the non-IRA account cannot be debited from the IRA.

Internal Mutual Fund Fees and Trading Costs

When you own a mutual fund the fees are charged in the form of an expense ratio. This cost is deducted out of the return of the fund before your share is allocated to you. In essence, it is a return (or gain) that was never reported to you as that portion was used to directly pay the expenses. For this reason, you do not need to total up your mutual fund fees and claim them as a deduction.

This works the same way with most trading costs. If you buy a stock and pay $9.95 for the trade, that $9.95 is added to the cost basis of the stock - so when you sell the stock the capital gain reported is reduced by the amount of the trading cost.

Paying for Advice

Some investment advisors offer financial planning services as well as tax preparation services. This is usually provided as part of one bundled service offering, and they charge based on a percentage of assets managed.

You may find that when you view costs on an after-tax basis these services are surprisingly reasonable.

Another thing to consider is the cost of actively managed mutual funds, which have a management team of research analysts studying stock market data in an attempt to earn higher returns. It costs more to pay for this team of research analysts, so actively managed funds have higher fund fees, usually in excess of 1% a year. 

Instead of using actively managed funds you could hire a fee-only investment advisor who uses low-cost index funds to build the portfolio. These funds typically have expense ratios less than .30%. By structuring services this way on an after-tax basis you may be able to get far more personal advice for about the same cost.

Separately Managed Accounts

For high net worth families with a large number of invested assets, many financial advisors will recommend separately managed accounts instead of mutual funds.

Now you own the stocks directly so there is no expense ratio. Instead, all fees are paid in the form an investment management fee that is debited from the account. If it is an IRA the fees debited from the IRA are paid with pretax dollars. If the account is a non-retirement account fees are subject to the 2% miscellaneous itemized deduction limit.