Investment Management Fees Tax Deduction
Structuring Your Fees Differently May Cost You Less
Investment management and financial planning fees were tax deductible through tax year 2017. They fell into the category of miscellaneous itemized deductions, and these deductions were eliminated from the tax code by the Tax Cuts and Jobs Act (TCJA) effective tax year 2018.
If you could have claimed them but didn’t, all is not necessarily lost. You can go back and amend a previously filed tax return for three years from the date you filed it or two years from the date you paid any resulting tax, whichever is later. And the TCJA is set to expire at the end of 2025 unless Congress renews it, so it’s not out of the question that this deduction could come back in later years.
These deductions and their qualifying rules were only available through Dec. 2017. You cannot claim these deductions on your 2018 tax return. You may be able to include these deductions in amended returns for years in which these rules applied.
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 percent of your adjusted gross income (AGI).
Example: If your AGI is $100,000, and you have $3,000 in 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—the amount that exceeds 2 percent ($2,000) of your AGI.
Many people pay such fees with a check, using after-tax dollars, because they assume this is the best way to do it. But there might be a better way to pay such fees so they cost you less on an after-tax basis if you have money in an IRA.
Paying Out of an IRA
You can pay investment management fees or financial planning fees that are structured as a percentage of assets directly out of the account being managed. It’s not considered a withdrawal from an IRA account when fees are paid this way. It is instead considered an investment expense, so you’re paying the fees with pre-tax dollars. If you’re at the 24 percent marginal tax rate, it costs you $760 for every $1,000 of fees paid this way on an after-tax basis.
It makes sense to pay fees directly out of traditional IRAs whenever possible because traditional IRA money will be taxed one day and you’re avoiding paying income tax on that portion when you pay fees out of this type of account. But it doesn’t make sense with Roth IRAs because these IRA withdrawals will never be taxed. Contributions are made with after-tax dollars. You’ll want to let the money grow tax-free in a Roth IRA as long as possible.
Unfortunately, you can only pay the portion of the fee attributable to that particular IRA from that 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.
Internal Mutual Fund Fees and Trading Costs
Mutual fund 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 because that portion was used to directly pay the expenses. You don’t have to total up your mutual fund fees and claim them as a deduction for this reason.
This works the same way with most trading costs. If you buy a stock and pay $10 for the trade, that money is added to the cost basis of the stock. 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 a bundled service offering, and they charge based on a percentage of assets managed. You might find that these services are surprisingly reasonable when you view costs on an after-tax basis.
Another thing to consider is the cost of actively managed mutual funds, which have a management team of research analysts who study 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.
You could hire a fee-only investment advisor who uses low-cost index funds to build the portfolio instead of using actively managed funds. These funds typically have expense ratios of less than 0.30%. You might be able to get far more personal advice for about the same cost 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
Many financial advisors recommend separately managed accounts instead of mutual funds for high net worth families with a large number of invested assets. 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.
For 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 prior to tax year 2018, and possibly again beginning in 2026.
Again, these rules do not apply to returns for tax years 2018-2025. You may only claim these deductions in amended returns for previous years.