As clients start planning for their 2018 taxes, some will learn that investment advisory fees they have been deducting in the past will no longer be deductible. The miscellaneous itemized deduction for investment fees and expenses was eliminated by the recent tax.
But this doesn’t mean that owners of IRAs and other investors can’t still receive a tax benefit for the fees they pay going forward. Advisors will be asked for new planning options. Here are suggestions about how to handle investment expenses most favorably in the future.
FEES VERSUS COMMISSIONS
It is perhaps notable that while regulators have generally tried to move investment firms toward charging fees instead of commissions, Congress has created a tax incentive for investors to prefer commissions instead of fees.
Commissions are effectively still deductible. Commissions charged to specific transactions provide the tax benefit of reducing the taxable gain (or increasing the loss).
By contrast, wrap and AUM fees and fees for nontrading services aren’t identifiable with individual transactions. They must be separately invoiced. Until 2017, they could be deducted as investment expenses, but no more. So they now provide no tax benefit.
As an example of the tax benefit of commissions, John buys stock shares for $95,000 and later sells them for $105,000, a $10,000 gain. He pays a 1% commission both on the purchase and sale — $950 and $1,050 respectively — a total of $2,000. The $950 is added to the tax basis of the purchased shares, and the $1,050 is subtracted from their sale proceeds when determining gain. John’s taxable gain on the shares is $8,000. He receives the equivalent of a deduction for the $2,000 of commissions.
Contrast this result with the case of Jane. She has $100,000 in an investment account in which she too has a $10,000 gain on a stock purchase and sale. She pays a 1.5% wrap fee of $1,500, plus another fee of $500 for investment advice, totaling $2,000. These fees aren’t part of any particular trade so they are billed to Jane as investment expenses. In 2018, these are not deductible. So Jane’s taxable gain is $10,000. She gets no deduction for the $2,000 fee.
PAYING IRA FEES
Even with the elimination of the tax benefit for the fees paid, clients can still obtain the equivalent of a tax deduction for some expenses. Owners of traditional IRAs are best able to do this.
The key is to pay traditional IRA fees directly from the traditional IRA, effectively gaining a deduction since the investment fees will be paid from pretax funds. The IRS has held consistently that retirement accounts can pay their own investment expenses, both commissions and fees, with no adverse tax effect to account owners.
As an example, Jack has an IRA with an annual fee of $2,000. He has the fee paid directly from his IRA. Jack does not have to include the $2,000 in income and owes no income tax on the $2,000 of pretax funds used to pay his account fee.
In the case of IRAs, the IRS also allows an IRA owner to pay its investment expenses from a separate taxable non-IRA account. Until 2017, owners could deduct such payments on their personal tax returns. But again, starting in 2018, they cannot.
When an IRA pays its own investment expenses with pretax funds, its owner obtains the equivalent of a tax deduction for the payment.
An IRA can also pay fees to an outside investment advisor, apart from the custodian, with the same tax result. The IRS held this in Letter Ruling 8951010. There, the owner of an IRA engaged an outside advisory firm to provide market-timing instructions for investments in his IRA. Payment for the advice went directly from the IRA trustee to the advisory firm. The IRS ruled that this was a proper expense of the IRA trust that could be paid with no adverse tax consequence to the IRA owner.
But while IRA fees can be paid from non-IRA taxable accounts, there is no longer a tax benefit to do so because of the loss of the tax deduction. For some clients, this is less of a blow that they might think. It is worth recalling that the itemized deduction was subject to the 2% adjusted gross income limit. For many high-income clients, the deduction was lost anyway because of the 2% threshold.
In addition, even if those clients were able to gain the deduction because their fees and other deductions exceeded that 2% limit, the deduction may still have been lost if they were subject to the alternative minimum tax.
For some clients, however, there could be a benefit to paying the IRA fees from non-IRA funds even though there is no longer a deduction. For example, if the IRA owner intends to keep funds in the IRA for many years or to leave a “stretch” IRA to a beneficiary, it might be better to pay the fees from non-IRA funds to avoid reducing the long-term growth potential of the IRA.
In addition, when the owner of an IRA is in a low-tax bracket or has had a loss year, a deduction equivalent has little or no value. Then, the owner may do best by paying IRA fees from outside the IRA and leaving as much as possible in the IRA to earn tax-favored investment returns.
ROTH IRA FEES
Roth IRAs are entirely different in this regard. Roth IRAs are funded with after-tax dollars, so it is never best to have a Roth IRA pay its own investment expenses. Doing so gives no equivalent deduction. There is no tax benefit to pay these fees from the Roth IRA. Doing that only reduces the amount in the Roth IRA that can earn tax-free investment returns. Always pay a Roth IRA’s expenses from outside the Roth account.
Fees for IRAs can be paid from non-IRA accounts. But what about paying fees owed for other accounts from an IRA? The answer is unequivocal: don’t do it.
An IRA must never pay any expenses but its own. If an IRA pays expenses for a non-IRA account, at best the payment will be a taxable distribution and at worst may be deemed a “prohibited transaction.” That may result in the termination of the IRA and its full balance being distributed and subject to tax.
Neither a traditional nor Roth IRA should ever be used to pay the expenses of any other account.
IRA custodian agreements can pose a trap for the unwary here. Some investment firms have standard customer agreements that let the firm take an amount owed to one account from any of the customer’s other accounts. This is dangerous.
If, say, an amount owed on a margin call is taken from a money market fund, that’s fine. But taking it from an IRA may be disastrous.
Pledging IRA funds to secure a debt is a prohibited transaction. Yet so many custodial agreements contain terms providing for this that the IRS has issued “temporary relief” for IRA owners subject to them. This relief says that the existence of such terms in a custodial agreement will not be a prohibited transaction — so long as they are not invoked.
When an IRA owner has multiple accounts with the IRA’s custodian, read the custodial agreement to see if such terms are in it. If they are, take steps to assure the IRA won’t be drawn upon for another account’s benefit.
Having a traditional IRA pay its own investment expenses can save on taxes compared with having the IRA owner pay them from a separate non-IRA account. But whether the tax saving is worth reducing the tax-favored IRA balance depends on the specific facts.
The expenses of a Roth IRA always should be paid from an account outside the IRA. Neither traditional nor Roth IRAs should ever be used to pay the expenses of any other account.