One of the many changes enacted by the Tax Cuts and Jobs Act of 2017 (TCJA) was the elimination of miscellaneous itemized deductions starting in 2018. This category included deductions for investment expenses which allowed you to deduct investment and custodial fees, costs-related trust administration, and other expenses, to the extent that they and other costs exceeded 2% of your adjusted gross income (AGI).
One strategy to deal with the elimination of this tax break is to deduct the investment fee for the management of your IRA directly from the IRA.
Let’s look into how this strategy plays out.
Who Should Consider This Strategy?
- Investors with IRAs containing a significant proportion of tax-deferred dollars, either from rollovers of employer sponsored pre-tax retirement saving plans or IRAs consisting of non-deductible contributions which have appreciated over time.
- Investors who are either close to retirement or already retired may be more inclined to find this strategy appealing, particularly if they are in a moderate to high marginal tax bracket and expect to remain so for the foreseeable future.
- Investors whose estate planning goals are focused on increasing the amount of after-tax wealth they will pass to their heirs.
Investors with IRAs should ask themselves: “How much of my IRA actually belongs to me and my heirs?”
The answer, for most IRA owners, is “less than 100%.”
For those with the characteristics I described above, the answer may be “as little as 50%.”
This is due to the tax burden imposed on withdrawals from an IRA, which are taxed at the participant’s marginal ordinary income tax rate.
In essence, federal—and in many cases, state—governments are your silent partners with an interest in your IRA. They have been biding their time as you accumulate and grow your retirement assets, but eventually they will claim their share. As a tax professional I know likes to say, “tax-deferred is not tax-free.”
By having advisory fees paid from your IRA, you are making your ‘partners’ pay for their proportionate share of the fees.
Cautions To Keep In Mind
- Do not use your retirement account to pay the expenses of any other account. For example, you cannot use traditional IRA money to cover Roth IRA costs.
- You can’t use the Roth IRA to cover traditional IRA fees, nor would it be advisable.
- In general, advisory fees for Roth IRAs should be paid from after-tax dollars (e.g., a brokerage account) if possible.
- This strategy is not a ‘once and done’ decision, but rather will need to be periodically revisited over time as circumstances and tax laws evolve.
Here are several case studies to help illustrate situations where this strategy makes sense.
Case Study 1: Recently Retired
Jim is age 66, recently retired, and has income from social security, investment income in the form of dividends, interest from municipal bonds, pension, and income from one company board that he sits on. For 2018 and the foreseeable future, Jim anticipates being in the 32% Federal tax bracket and the 9% California tax bracket (41% combined).
Jim has approximately $3,000,000 in his investment portfolio, consisting of $2,000,000 in his IRA and $1,000,000 in his brokerage account. His entire IRA consists of dollars rolled over from his company retirement plans and the entire amount is all tax-deferred. Jim pays approximately $27,000 per year in investment advisory fees.
In past years, he had been paying from his brokerage and was able to deduct a significant portion of those fees as a miscellaneous itemized deduction.
Jim could continue to pay his advisory fees from his brokerage account, but in doing so would bear the full burden of the cost himself. Alternatively, if he were to have his IRA pay its proportionate share of the fees, he would pay $9,000 from his brokerage account and $18,000 from his IRA. Given his current combined tax rate of 41%, by having his IRA pay its own way, he is essentially paying $10,620 of the IRA management fee with “his” money and the remaining $7,380 with money that represents deferred tax liability.
Case Study 2: Conservative Accumulator
Fred is also age 66 and recently retired. He has income from social security and some investment income, but is in a much lower tax bracket than Jim. Fred is expecting to be in the 12% federal tax bracket and lives in a state with no income tax. His marginal tax rate is 12%.
Fred has approximately $1,000,000 in his investment portfolio, consisting of $250,000 in his IRA and $750,000 in his brokerage account. His IRA consists of a combination of non-deductible contributions made over the years, some pre-tax savings, and some after-tax payroll contributions. Fred’s aggregate after-tax contributions represent approximately $150,000 and the remaining $100,000 represents tax-deferred dollars. His annual advisory fees are $10,000.
Since Fred has a substantial basis in his IRA, if he were to take any distributions at this point, only a portion of those withdrawals would be exposed to tax. Given the current set of assumptions, for each $1 withdrawn, 40 cents would be considered the tax-deferred portion and subject to tax while the other 60 cents would be a return of capital.
At his current marginal tax rate of 12%, for each dollar withdrawn, Fred would pay 4.8 cents in tax, and keep the remaining 95.2 cents. Under these circumstances, there is no strongly compelling reason for Fred to have his IRA pay for its proportionate share of the advisory fees.
Fred might be much better off by conserving the money in his IRA, adopting a more growth-oriented investment stance, and paying the advisory fees from his brokerage account.
Case Study 3: Multi-Generational Investor
John and Jill are a married couple in their late seventies. They have accumulated significant assets in the form of commercial real estate, a primary residence, a vacation property, and liquid assets, which includes $6,000,000 in a brokerage account with cost basis of $2,000,000, and $2,000,000 in IRAs, all of which are tax-deferred contributions and growth.
They have substantial income from their RMDs, their rental property, income from social security, and income from investments and are in a combined federal and state tax bracket of over 40%.
Their goals are to continue to live their current comfortable lifestyle and to pass along as much as they can to their heirs when they are both gone.
John and Jill live within their means and anticipate they will eventually leave a sizable estate to their children. When the time comes, the assets outside of the IRA will receive an adjustment (a ‘step up’) in cost basis while the IRA assets do not. For John and Jill, it makes sense to have the IRAs pay their own proportionate share of their advisory fees.
Case Study 4: All IRAs Are Not Created Equal
Let’s assume the same set of circumstances as in case study 3 with one exception: John and Jill each have a Roth IRA, and each holds $250,000. In this scenario, we would still advocate for the traditional, tax-deferred IRAs to pay their own proportionate share of the advisory fees, but we would strongly recommend that John and Jill pay the advisory fees for their Roth IRAs out of their brokerage account. This is because the Roth IRA assets are tax-free, not only for John and Jill’s lifetimes, but also for the lifetime of their heirs.
For this reason, preservation and growth of the Roth IRAs should be a priority.
It’s clear that there is no ‘one size fits all’ recommendation when it comes to the source for the payment of advisory fees associated with a traditional IRA. Each investor’s current circumstances, future goals, assumptions about tax rates and rates of return, time horizon, and similar factors will all influence the recommendation for or against having the investors IRA pay for its proportionate share of any advisory fees.
Check in over time
Remember: periodically review your strategy over time, as circumstances and tax laws evolve.
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