“How much does it cost?”
That’s the question prospects and clients inevitably ask at some point after listening to an advisor present a detailed investment proposal
. It’s a fair question. After all, the investor’s future, and the money they have worked their entire life to accumulate, are at stake.
Of course, there are many ways to explain to investors the value of working with an advisor. But, many advisors don’t realize that in certain cases, their clients can deduct a portion of the advisory fee from their tax return
– thereby reducing the fee’s effective rate and helping to address the fee discussion.
For income taxes, remember that Uncle Sam “giveth” and Uncle Sam “taketh.” For taxes, it is usually much more about the “taketh,” but for advisory fees
it can fall under “giveth.”
When are advisory fees tax deductible?
Of course nothing about paying taxes is ever easy or direct, so the answer is “It depends.” Here are some things to consider when trying to determine if you can deduct the advisor fee.
Under current tax law, investors may be able to deduct the amount of the advisory fee that exceeds 2% of their Adjusted Gross Income (AGI). This deduction would be on Schedule A under Miscellaneous Deductions. (Note, however, that if the investor is subject to the Alternative Minimum Tax (AMT), the advisory fee deduction (and most other deductions) would be considered tax preference item and would be disallowed. Also, for advisors working with a taxable trust
(IRS Form 1041), this 2% AGI reduction would not apply. Instead, the advisory fee can generally be deducted from taxable income
Bear in mind also that:
- If the investment management fees apply to an investment account that produces both taxable and tax-exempt income, only the portion of the fee that applies to investments that produce taxable income can be deducted (the amount of the fee that is related to municipal bonds, for example, would need to be prorated and not deducted).
- Many retirement plan custodians charge an annual maintenance fee. It is important to understand how the payments are structured before considering whether the payment is deductible. For example, management fees paid from an IRA cannot be deducted. They simply reduce the value of the IRA account. However, IRA management fees that are paid from outside of the IRA can generally be deducted as investment expenses (subject to the 2% AGI limit).
- In some cases, if the advisory fee does not quite exceed the 2% AGI floor, but is close, there is the possibility of having the client defer payment of the advisory fee until the following year and combining two years of payments in a single year. For firms that typically withdraw fees in the fourth quarter, this might be worth considering.
Be sure to consult a tax advisor if your client is interested in planning for a tax-efficient way to pay management fees as there are many considerations based on your client’s specific facts and circumstances.
Deducting advisory fees: A hypothetical example
Let’s look at a hypothetical example of how the stated and effective advisory fees can differ from one another
. Consider the following hypothetical married couple filing jointly (MFJ):
Take 2% of AGI. The amount of advisory fee (and other deductible miscellaneous expenses) above 2% that may be deductible.
- AGI x 2%
$400,000 x 2% = $8,000 (Misc. deductions – sometimes called the 2% AGI Floor)
Subtract 2% AGI Floor from Investment Management Fees for possible deduction.
- Advisory Fee Less 2% Floor
$15,000 - $8,000 = $7,000 (Amount that may be deducted from taxable income)
Calculate dollar amount of reduced taxes being paid.
- Tax Savings x Marginal Federal Tax Rate
$7,000 x 33% = $2,310 (Dollars not paid to IRS = tax savings)
Calculate effective advisory fee, taking into account tax savings.
Step 5: The outcome
- Stated Advisory Fee Less Tax Savings
$15,000 less $2,310 = $12,690 (Effective advisory fee)
0.85% = Effective advisor fee in bps ($12,690/$1,500,000)
- Hypothetical client saved $2,310 in taxes
- Advisory Fee dropped by 15 bps to 85 bps
Note that in some respects this hypothetical example could be conservative. The advisory fee could potentially be further reduced
- state income taxes were also taken into account;
- the example was based on a taxable trust, in which case the fee could potentially drop to 0.57%.*
In short, the answer to “How much does it cost?” really is “It depends.” Of course, consult your firm’s policies and a tax professional
, as each client’s situation is unique. Nothing is easy with IRS, but sometimes Uncle Sam does “giveth” in the presence of taxes.
The bottom line
The question of the advisory fee inevitably – and legitimately – comes up in client conversations. Although advisors are typically worth every basis point of their fee, in some cases there may be ways to help reduce the stated advisory fee through certain tax deductions. Consider consulting your firm’s policies and a tax professional to identify which of your clients and prospects may be able to benefit from available tax deductions.