Monday, December 29, 2014

How to Take a Tax Deduction for Investment Management Fees / Financial Planning and Investment Management Fee Tax Deductions

Dana Anspach for writes: Investment management fees and financial planning fees may be tax deductible. Some of 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 it 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 pretax 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.
This ability to deduct investment management fees does not apply to the expense ratio in a mutual fund. This means you cannot total up internal mutual fund fees and take those as a deduction. This is one reason why actively managed funds may not always be the best option.
Internal Mutual Fund Fees Are Not Deductible
An actively managed mutual fund has a management team of research analysts studying stock market data in an attempt to earn returns that are superior to simply owning an unmanaged basket of stocks in the form of an index fund. 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. As discussed, you cannot deduct these fees.
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%.
Assuming you have at least some money in an IRA now the 1% you are paying to the advisor (instead of to the mutual fund) will at least partially be paid with pretax dollars. 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 amount of investable assets, many advisors will recommend separately managed accounts instead of mutual funds. Now you own the stocks directly and there is no expense ratio – instead all fees are paid in the form an investment management fee that is debited from the account. For families with millions in an IRA this may be a slightly more tax efficient way to structure things as you have an extra .30% being paid with pretax dollars (The .30% being the expense ratio that would be going to an index mutual fund.)
If the money is not in an IRA, the accounting costs of tracking individual stock trades may exceed any potential tax savings of taking the fees as a miscellaneous itemized deduction.
Paying for Advice
Some investment advisors offer financial planning services as well as tax preparation services all as part of one bundled service offering where they charge based on a percentage of assets managed. You may find that when you view costs on an after-tax basis these services make more sense than what you may otherwise have thought. 


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