Q: I like my investment advisor a lot, and he has done a great job managing my investments during my retirement years. His annual fee is approximately 1percent of the value of the investments that he manages, and it is well worth it because I would be a lot worse off if I were trying to do it myself. Are his fees tax-deductible? Does it matter whether I pay his fees from my trust brokerage account or my IRA retirement account?
A: Whether you should pay your investment management fees from your IRA account (pre-tax dollars) or from a non-retirement account (after-tax dollars) depends on your individual situation.
The IRS classifies investment management fees as miscellaneous itemized deductions along with other deductions including tax preparation fees, un-reimbursed employee expenses, business liability insurance, dues to chambers of commerce and professional societies, educator expenses, job search expenses, license and regulatory fees, tools and clothing that you use in your job, and union dues. You report your miscellaneous itemized deductions on Schedule A of your tax return and then you reduce them by subtracting 2percent of your Adjusted Gross Income.
For example, let's assume your investment advisory fees were $10,000 and your tax preparation fee was $1,000. Also assume that your AGI was $100,000. Your total miscellaneous itemized deductions of $11,000 will be reduced by $2,000 (2percent of $100,000) leaving a deduction of $9,000. If you are subject
to the alternative minimum tax, your miscellaneous itemized deductions could get thrown out altogether along with certain other itemized deductions, including the state and local taxes you pay. As you can see, the answer to your first question, "Are investment management fees deductible?" is "Maybe."
The answer to your second question is a little more straightforward. If you are working and trying to maximize your contributions to your retirement plan, then you should consider paying the fees from the after-tax funds in your trust account. That way you will leave more money in your retirement fund to grow tax-deferred.
However, if you are retired and no longer contributing to your IRA or other retirement plan, then you are likely to be better off with the investment advisory fee coming straight out of the retirement account. That's because an advisory fee withdrawn directly from a retirement account is not reported as taxable income. Think of it as a tax-free withdrawal. Here is an example. Rob and Mary Jane, both single, are retired and have $200,000 IRA accounts. They each pay a $2,000 investment management fee. They have identical adjusted gross incomes of $100,000 and identical itemized expenses. Rob withdraws $10,000 each year from his IRA and pays his $2,000 investment management fee from his checking account. He reports a $10,000 taxable IRA distribution on his tax return and claims a $2,000 miscellaneous itemized deduction on Schedule A that is reduced to zero by the 2percent AGI limit (2percent of $100,000). Mary Jane withdraws $8,000 each year from her IRA and has her investment management fee withdrawn directly from her IRA account with no tax consequence. Mary Jane is smiling and Rob is frowning because Rob's taxable income is $2,000 higher than Mary Jane's even though they both withdrew the same amount from their IRA account.
Kenneth B. Petersen is an investment adviser and principal of Monterey Private Wealth, Inc., in Monterey. Send questions concerning investing, retirement or estate planning to 2340 Garden Road, Suite 202, Monterey 93940 or email@example.com.