Any tax dollars you can save directly impact your bottom line. It’s a guaranteed impact as well, and in an uncertain world of investing, guaranteed returns are either non-existent or next to nothing.
It always helps to reduce your tax burden as much as possible. Fortunately, the IRS does allow investors to deduct some of the investment management fees they pay. The tax treatment of investment fees isn’t as good as it could be – or should be. It is however, something that should be taken into consideration.
Are my investment management fees tax deductible?
The tax code on the deduction of investment fees is found in the IRS code section 212. The code says expenses you incur which are associated with:
- the production or collection of income, or
- the management, conservation, or maintenance of property held for the production of income, or
- the determination, collection, or refund on any tax
as potentially deductible fees. I say “potentially”, because the amount deductible is subject to the 2% miscellaneous itemized deduction floor.
The “production of income” part is important. The “income” must be taxable so the IRS can get their portion. Muni bonds generate tax free income (sometimes at the state, federal and local level). Fees paid for managing a municipal bond portfolio are therefore not deductible.
Miscellaneous itemized deductions
Qualifying investment fees are tax deductible, but only as a miscellaneous itemized deduction. Miscellaneous itemized deductions are subject to the 2% of AGI (adjusted gross income) floor, and an AMT or alternative minimum tax adjustment (if applicable).
In an era of massive budget deficits and out of control federal spending, at least the IRS allows investors some sort of tax benefit to hire professional investment management and financial planning help. While not everyone will qualify for this tax deduction, many people will!
What about my IRA’s and 401k fees, are they tax deductible?
The tax deductible treatment of IRA and 401k fees is a bit different. If financial advisor or investment manager fees are deducted directly from an IRA or 401k, the fees are effectively paid with 100% pre-tax dollars. Essentially, they’re deductible without even deducting them. This is because you never paid taxes on the amount of fees withdrawn to compensate your financial manager in the first place.
There’s a downside to this however. Paying investment fees from an IRA means reducing the amount IN the IRA, and reducing the long term benefits of tax deferral. You fund your IRA and 401k for the purpose of gaining a tax benefit right? Paying fees from those accounts reduces the amount of tax benefit, because you’re reducing the IRA or 401k account value.
Note: you cannot pay investment fees or financial planning fees from an IRA or 401k account for anything BUT the specific IRA or 401k. For example, if you have 4 accounts and only two are IRA’s, you can’t pay the investment fees for all four accounts from one or both IRA’s.
Drawing excessive fees from an IRA (to cover fees attributable to a taxable account) may constitute an IRA withdrawal. It may even generate early withdrawal penalties! In a worst case scenario, doing so may even deem the IRA disqualified.
Where should I pay my investment management fees from?
Paying investment fees from a taxable account means leaves more IRA and 401k assets to grow tax deferred. For most investors, this is the best solution. It does however, mean you’re limited to taking whatever tax deduction (if any) you can get as a miscellaneous itemized deduction.
In our fiduciary advisory practice, we generally use taxable accounts to pay investment fees. Clients keep their tax deferred accounts growing tax deferred, and some clients can deduct our fees as a miscellaneous itemized deduction.
For other clients, we deduct their investment fees proportionally across any taxable accounts and IRA’s we manage for them. Which is right for you? As your financial advisor and tax professional. It really depends on your specific tax and financial situation.
If you have both taxable and IRA accounts, it’s hard to say which method of paying investment fees is best. It really depends on how your accounts are structured, your time horizon, and IF you can benefit from deducting your investment management fees at all?
Why does time horizon and account structure affect where I pay investment fees from?
Retirees have a shorter time horizon than a young investor. Retirees are typically invested more moderately, or even somewhat conservatively. The power of tax deferral doesn’t benefit them quite as much because their investment returns are a bit lower. In this situation, it may make sense to spread investment fees over all accounts proportionately.
Younger investors have a long time horizon. Typically – and especially if they’re a more aggressive investor – paying investment fees from taxable accounts allows them to leave tax deferred assets alone as long as possible. Younger investors should consider paying investment management fees from taxable accounts, especially if they get any benefit from any sort of miscellaneous itemized deduction.
Tax deduction of financial and investment related fees summarized
Investment fees paid from taxable accounts – or by check for example – can be deductible. They may be deductible only in the amount they exceed 2% of your adjusted gross income, as a miscellaneous itemized deduction.
If your fees are $5,000 per year, and your AGI is $100,000, you may be able to deduct $3,000 on your tax return. Since you’re likely in a 25% bracket, this could mean saving $750 ($3,000 times 25%). This isn’t too bad, considering tax deductions are quite hard to come by!
Where you pay your investment fees from really depends on your specific tax and financial situation. What’s your AGI? Will you even qualify for a tax benefit? Some do, some don’t.
Finally, how your accounts are allocated affects this decision as well. Younger investors are likely better off paying fees from a taxable account, leaving their tax-preferenced accounts to grow. Older, more moderate investors, are likely better off spreading their fees prorated across all account types.