The following is a guest post from Marotta Wealth Management.
I often get asked, "Are investment management fees tax deductible?" The answer is not a simple "yes" or "no." Like many tax questions, the answer is "It depends."
Investment management fees are a tax-deductible expense. They can be listed on Schedule A under the section "Job Expenses and Certain Miscellaneous Deductions." Line 23 includes investment expenses. These expenses get added into unreimbursed employee expenses, tax preparation fees, safe deposit boxes and other qualifying expenses.
Unreimbursed employee expenses can include professional dues, required uniforms, subscriptions to professional journals, safety equipment, tools and supplies. They may also include the business use of part of your home and certain educational expenses.
All of these miscellaneous deductions are totaled. You only receive a tax deduction for the amount that exceeds 2% of your adjusted gross income (AGI) from line 38 of your Form 1040. If your cumulative expenses are under 2% of AGI, you will not get a deduction.
For most of our working clients, their miscellaneous deductions fall far short of the 2% AGI threshold. But when clients retire, they are much more likely to qualify.
If your expenses are close, you gain from lumping most of your expenses every other year. For example, if your AGI is $100,000 and your miscellaneous expenses average $2,500 a year, in most years you will only get a $500 deduction. But if you can pay the same bills in January and December of one year, you might be able to have $5,000 in deductions one year and zero the next. That means you could have a $3,000 deduction every other year. In next year's 28% tax bracket, this would save you $560 more in taxes.
Even if you can't deduct investment management fees directly, you can still pay a portion of the fee with pretax dollars. Investment management fees can be deducted directly from the accounts for which they were charged.
Many fee-only advisors charge a percentage of assets under management. But they can also prorate those fees back to the accounts they are managing. For traditional IRA accounts, the fee is not considered a withdrawal and therefore is not a taxable account. The fee is considered an investment expense. Thus this fee is being paid with pretax dollars. And the cost is discounted to clients by their marginal tax rate.
I've seen advisors take their entire management fee from IRA accounts. I don't think that is warranted by the letter or the spirit of the tax code. Any fee taken from an IRA account should be justified as a fee for the management of a pretax account. You can't simply start paying your bills from an IRA as a nontaxable withdrawal.
Similarly, any management fees paid directly from an IRA account should not be listed as a miscellaneous expense on Schedule A trying to qualify for an additional tax deduction. Only expenses paid from a taxable account should be listed as a miscellaneous expense.
There is no advantage in trying to pay the entire fee from a taxable account in an attempt to boost your deductions. If you pay $2,500 in management fees, it is better to pay $1,000 from an IRA with pretax dollars than to pay for it separately to get a $500 tax deduction. Any amount paid from an IRA is equivalent to getting that same amount as a tax deduction.
Although getting money out of a traditional IRA tax fee is an advantage, taking management fees out of a Roth IRA is not. There are limits on getting money into a Roth account where it will never be taxed again. We recommend paying the portion of management fees prorated to a Roth account out of your taxable account. This allows as much money as possible to stay in your Roth.
One of the advantages of working with a fee-only financial planner is that fees can be taken from the accounts under management or paid separately, depending on which is more advantageous. If fees are stuck on commission-based products, you can't choose to pay the fees for a Roth account separately from a taxable account in order to allow the Roth to grow unimpeded.
This is another advantage to having fees based on assets under management rather than a separate fee or an hourly charge. Management fees are easily justified taken directly from accounts including IRA accounts where you can pay with pretax dollars.
Many advisors charge a percentage of assets under management and then offer comprehensive wealth management advice without an hourly charge. This is ideal. If these charges were separated, less of the fee could be paid with pretax dollars.
No one likes to pay fees. Hidden fees in many ways are easier psychologically. We recommend that when you need unbiased financial advice, seeking a fee-only financial planner makes sense. And it helps knowing there are tax-efficient ways to pay management fees.