Advisor Fees, Investment Management

Are Investment Fees Tax Deductible?

Are My Investment Fees Tax Deductible?

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 – however it is something that should be taken into consideration.

The tax code on the deduction of investment fees is found in section 212. It defines expenses for the production of income associated with an individuals money and financial issues as a potentially deductible investment fee. I say “potentially” because the amount deductible is subject to the 2% miscellaneous itemized deduction floor.

IRS section 212 cites three categories of deductible costs:

  • 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

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), and therefore fees paid for managing a municipal bond portfolio are not deductible.

Qualifying investment fees are tax deductible 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 spending, at least the IRS allows investors some sort of tax benefit to hire professional investment management and financial planning help.

Are My Investment Fees Tax Deductible?

The tax deductible treatment of IRA and 401k fees is a bit different. The IRS also allows for deductibility of investment advisor fees for those tax preferenced accounts, and if investment fees are deducted directly from the IRA the fees are effectively paid with 100% pre-tax dollars.  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.

It’s important to 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. That may constitute an IRA withdrawal and possibly even generate early withdrawal penalties. In a worst case scenario doing so may even deem the IRA disqualified.

Paying investment fees from a taxable account means leaving more IRA and 401k assets to grow tax deferred. For most clients, this is the best solution even though it means taking whatever tax deduction they can get as a miscellaneous itemized deduction.

Investment fees paid FROM an IRA or 401k on behalf OF the IRA or 401k itself are paid with pre-tax dollars (generally speaking). For this reason the IRS does not allow a deduction of those investment fees. This makes logical sense as the fees paid for an IRA or 401k from the IRA or 401k have never been taxed in the first place. Keep in mind the IRA or 401k CANNOT pay investment fees for taxable accounts – that would be a taxable distribution.

In our private client practice we generally use taxable accounts to pay investment fees. Clients keep their tax deferred account growing tax deferred, and some clients can take the fees as a miscellaneous itemized deduction. There are other clients which we deduct their investment fees proportionally across any taxable accounts and IRA’s we manage. Which is right for you?

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 as well as your time horizon, and also IF you can benefit from any portion of the miscellaneous itemized deductions.

For retirees (shorter time horizons than a young investor) who are invested more moderately or even somewhat conservatively, the power of tax deferral doesn’t benefit them quite as much over the long run because their returns are lower. In this case it may make sense to spread the fees over all accounts proportionately.

For younger investors with long time horizons – especially if they’re more aggressive in nature – paying investment fees from taxable accounts and leaving the tax deferred assets alone as long as possible may make the most sense. Younger investors with more moderate or aggressive investment plans should consider paying the fees from taxable accounts especially if they get any benefit from any sort of miscellaneous itemized deduction.

Nov 20 2012

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