When investors sit down with their financial advisor to prepare their tax returns next year, they'll be confronted with new rules that for many mean an increase in the cost of having an advisor.
The new tax law passed by Congress last year ends deductions on some types of advisory fees, including those based on the value of assets under management (AUM), a common way advisors charge clients.
For both the client and advisor, this change is causing quite a bit of angst. Yet much of this worry is needless because many clients can still get a tax savings on some fees by using an equivalent strategy.
The IRS has long held that qualified retirement accounts, such as traditional and other types of individual retirement accounts, can pay their own expenses. As funds in these accounts are tax-deferred, there are no tax consequences to using this money to pay advisory fees related to the management of these accounts.
More from FA Playbook:
Amid heightened equity volatility, what's an investor to do?
Think before following a broker who leaves their firm
Keep emotions under control when investing
(Money taken out of these accounts usually triggers ordinary income tax and, for those under age 59½, a hurtful 10 percent penalty — but not in this case, because the IRS doesn't consider these payments to be distributions.)
To the extent that an individual's assets are in a traditional IRA, IRA rollover or other tax-deferred account (including Simplified Employee Pension IRAs or pension plans) and are under an advisor's care, you can pay the advisor the proportionate amount of fees directly out of these accounts with pretax dollars.
This strategy serves as an effective tax deduction. Roth IRAs are funded with post-tax income, so there's no tax advantage to paying advisory fees out of these accounts. This merely diminishes retirement assets, so it's usually best to pay Roth fees out of a taxable account.
This alternative strategy has long been available, but many weren't aware of it because advisory clients were happy to get the deduction on AUM fees, often about 1 percent annually. Now that this straight-out deduction is gone, advisors are receiving calls from nervous clients who say they can no longer afford their services, and advisors are alerting them to the alternative strategy. Investors who want to take this route should talk to their advisors about it.
Many Americans have a significant portion of their assets in tax-deferred, employer-sponsored retirement plans, including 401(k) plans, 403(b) plans for teachers and pension plans. Their portion of advisory fees and other expenses is often taken directly from their accounts, so these account holders are already getting the effective deduction.
Sign Up for Our Newsletter Your Wealth Weekly advice on managing your money SIGN UP NOW Get this delivered to your inbox, and more info about about our products and services.
By signing up for newsletters, you are agreeing to our Terms of Use and Privacy Policy.
Paying expenses directly from these retirement accounts is a tax-savings opportunity for millions of Americans. As of early 2017, Americans held $7.9 trillion in IRAs, $660 billion of which was in Roth IRAs, according to the Investment Company Institute. (As of early this year, Americans held nearly $5.3 trillion in 401(k) plan accounts, according to the institute.)
Though not new, the alternate deduction method is good news for many, especially now that fewer people will be able to itemize deductions under the new tax law. Paying fees out of tax-deferred accounts is every bit as beneficial as doing so from taxable accounts because, as with an outright deduction, this is tax you never have to pay. Funds in your tax-deferred accounts are subject to tax when you take money out, usually in retirement, when your tax rate will probably be much lower than during your working years.
For many well-heeled taxpayers, the equivalent strategy may even be better than the outright deduction, because the deduction involved a floor determined by 2 percent of adjusted gross income. So those with an AGI of $300,000 couldn't deduct the first $6,000 of fees. But there's no AGI floor on fees paid directly from tax-deferred accounts.
"By diversifying assets within IRAs according to a sound asset-allocation strategy, you can significantly reduce the potential for net investment losses."
Depending on their goals and priorities, some people have good reason to pay advisory fees on tax-deferred accounts from taxable accounts. For example, if the holders of IRAs plan to leave them to beneficiaries as stretch IRAs (which the heirs can then grow themselves), they may want to avoid diminishing the account to let it grow larger over the long term. But in most cases people use their IRAs to pay their expenses in retirement.
Beginning April 1 of the year after you turn 70½, contributions to traditional IRAs must cease and holders are required to begin taking required minimum distributions, withdrawing money on a set schedule.
Also, the deduction-equivalent strategy may have little, if any, value in a year when your tax-deferred account experiences a loss. In such years holders might be better off not paying fees from these accounts.
Yet by diversifying assets within IRAs according to a sound asset-allocation strategy, you can significantly reduce the potential for net investment losses. And the chances for growth are perennially increased by tax deferral on contributions and investment gains — the whole point of having these accounts.
— By David Robinson, founder/CEO of RTS Private Wealth Management
