If you work with an investment manager, you pay an investment management fee for the service.
Since investment management fees are substantial, it is smart to maximize any related tax benefits.
Prior to the Tax Cuts and Jobs Act of 2017, investment management fees were deductible as Miscellaneous Itemized Deductions subject to the 2% of AGI Threshold.
Whether you received a tax benefit for these fees depended on your facts and circumstances. Notably, fewer taxpayers received a tax benefit than received a tax benefit.
This makes the law change a moot point for most taxpayers.
The taxpayers who received a tax benefit are at a change point with what to do next. The question is, how can I tax efficiently pay investment management fees?
The common practice is for investment managers to suggest paying the fees out of your IRA or switching to commission based products. Both options have their pros and cons.
If you are like “most taxpayers” and never received a benefit. Don’t change anything. You can probably stop reading too.
If you’re one of the few taxpayers who did receive a tax benefit then you might benefit from continuing to read.
Tax Cuts and Jobs Act of 2017
An important point to consider from the start is….
Most individual taxpayer changes under the Tax Cuts and Jobs Act of 2017 are TEMPORARY.
A sunset on the “new rules” is lurking in 2026. This means changes like the elimination of Miscellaneous Itemized Deductions subject to the 2% threshold are paused. Not permanently eliminated.
Deductibility of Investment Management Fees
The deductibility of investment management fees comes from Internal Revenue Code Section 212. This section covers “Expenses for the Production of Income.” These are ordinary and necessary expenses for:
- Production or collection of income
- Management … of property held for the production of income
Also noted in this section is that for an expense to be deductible it must be attributable to taxable income. Therefore, if you have an expense related to your tax-exempt municipal bond the corresponding expense is not deductible.
If you pay a traditional Assets Under Management (AUM) or wrap fee (C-shares), then an allocation of your taxable versus tax-exempt holdings is calculated. This splits your fees into a deductible and non-deductible bucket.
With your deductible fees calculated you then report it on Schedule A as a Miscellaneous Itemized Deduction subject to the 2% threshold. At least when it’s available… like prior to 2018 or 2026 and later (maybe).
What if I pay investment management fees from my IRA?
As discussed above, your expenses are deductible when it’s related to the production of taxable income.
If you have an investment expense charged on your IRA then would the expense be deductible?
IRAs are tax-deferred and do not create ongoing income. Therefore, any investment management fees paid on your IRA are not deductible. Under the old or new law, you were not allowed to deduct these expenses on Schedule A.
IRA’s are pre-tax retirement accounts. When investment management fees are charged on an IRA, then the fees in the account are paid with pre-tax money.
This tax favored treatment is your tax benefit. That’s why you could not deduct investment management fees on Schedule A.
Cool… but what if I want to pay fees from just one “bucket?”
Now you understand how expenses paid on each bucket of money are treated for tax purposes.
The next question on your mind is… what if I want to pay for my non-IRA AUM fees from my IRA? …or… what if I want to pay for my IRA AUM fees from my non-IRA funds?
We’ll start with the easy one.
The IRS has always allowed you to pay your AUM fees out of your non-IRA funds no matter what the AUM fees are related to. Traditional IRA, Roth IRA, taxable brokerage, whatever … those fees can be paid with your non-IRA funds.
Yet, the pause in the deductibility of investment management fees on Schedule A has a lot of investment managers and their clients motivated to switch the payment of fees to come from the IRA.
Why? Because the tax benefit of paying those from non-IRA funds is gone! Well… paused.
Remember the term “ordinary and necessary?” You should because it might be the most important term in the tax code…
To deduct AUM (or any) expenses in an IRA, the expense must be ordinary and necessary FOR the IRA. Therefore, the payment of expenses for another account is NOT an ordinary and necessary expense of the IRA.
If you paid AUM fees for other accounts then it would be treated as a taxable distribution. It’s no different than paying your cell-phone bill with the IRA. If it’s not ordinary and necessary expense of the IRA… It’s not an allowable expense.
Maybe a taxable distribution doesn’t scare you because you’re 59 ½ or older. Fine. Maybe this will.
The Prohibited Transaction Rules state that any transaction with a “disqualified person” can be subject to a penalty tax of up to 100%. This means that the entire account has been fully distributed for tax purposes!
Your million-dollar nest egg just got cut in half.
What should I do?
This is a great question. One you should be asking. Yet, to know your answer depends on your facts and circumstances.
If you work with a broker dealer who has the option of charging an AUM fee or commission then commissions are an option. Commissions are capitalized into the basis of the asset making the advisor expense a pre-tax benefit.
Commissions have their own issues in terms of conflicts of interest. In fact, this is what the fiduciary rule is out to change.
If you paid your entire AUM fees with non-IRA funds in the past, then you could begin paying the investment manage fees related to the IRA with the IRA.
We might get caught up in the tax benefit aspect of this decision. Granted, when all things are equal this is where the focus should be.
Yet, it’s important to remember that wherever you pay your investment management fees from it will impact the growth on that account. Here is an example:
Ken has an Traditional IRA with $1,000,000. Patty has a Roth IRA with $1,000,000. To preserve the growth of the Roth IRA you decide not to pay any investment management fee from the Roth IRA. In total, you pay a 1.5% investment advisor fee on all your assets. In total, this is $30,000 on $2,000,000. To keep things simple, let’s pretend you decide it’s OK to pay 100% of the fee from your Traditional IRA. Both accounts are invested to give you an expected 8% rate of return.
After 10 years, Patty’s Roth IRA will be worth $2.2 million. While Ken’s Traditional IRA will be worth $1.9 million. A $300,000 difference in account balance!
There is a material difference in account balances based on where you pay the fee.
You should also consider a breakeven analysis on where to pay the fee. Here is a chart created by Michael Kitces to give general guidance on where you’re best suited to pay the advisor fee:
In the end, it’s all about knowing the rules, doing the math, and clarity on what you want from your money.
Do you want to understand how to make your money work for you and keep more of what you have earned?
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Nate Byers a Madison, WI CPA Financial Advisor, and all rights are reserved. Read the full Disclaimer in the footer below.