With advisor fees no longer deductible, paying them comes with tax tradeoffs

Wealthier investors winced when they lost a valuable tax deduction for the five- and six-figure fees they pay to their financial advisors each year. While a portion of the lost perk can be cloned, the move comes with a price: diminished investment returns over time.

When advisor fees are calculated based on assets under management, and when those assets swell, the fees are typically bigger. Paying them out of an IRA, which replicates the effect of the lost deduction, excises a slice of the plan’s assets. A smaller pot to grow means less money to generate investment gains. For clients, it could potentially be a bad trade: smaller savings today at the cost of heftier profits decades down the road in retirement.

Bloomberg News

With the stock market up more than 50% since the start of 2018, the year the so-called investment expense deduction was canned, retirement portfolios have swelled, but so have their AUM-based fees.

Although there’s no data on how many RIAs and broker-dealers now yank fees directly out of IRAs as opposed to having clients pay them out of pocket — Cerulli Associates, among other research groups, doesn’t track this — some advisors say it’s standard procedure. “It’s quite common,” says Denis Smirnov, a CFP at Gordian Advisors, an RIA in Tucson, Arizona. Morgan Hill, the CEO of Hill & Hill Financial, an RIA in Woodstock, Georgia, says that the loss of the deduction in part led his firm to reduce its fees but that it automatically deducts them out of a client’s IRA: “I don’t know anyone who’s not doing that.”

Prior to the 2017 tax law, investors could deduct investment advisory fees once they exceeded 2% of their adjusted gross income (AGI), a key figure on individual returns that shapes how much money a taxpayer ultimately owes to Uncle Sam.

While the new law allows investors to deduct commissions on their federal returns, it bars them from deducting advisory fees, whether based on the size of their portfolio, a retainer, a flat rate or by the year or hour.

The one exception is for fees paid for management of a traditional IRA. Under IRS rules, those can come straight out of the plan, and since they’re being paid with money on which tax hasn’t yet been paid, they’re the functional equivalent of a deduction. And they don’t trigger any taxes or early-withdrawal penalties. But an IRA can’t be used to pay advisor fees on non-IRA investments. Paying fees out of a Roth IRA makes zero sense, as the plan contains after-tax dollars and doing so just diminishes the tax-free growth of that pot.

Before the 2017 law change, the investment expense deduction meant good savings for many investors.

While the 2% threshold was typically too high for ultra-wealthy clients, it was easier to hit for mass affluent and some high net worth clients. In a simplified example, a person who made $200,000 a year, had a retirement portfolio of $1 million across various accounts and plans and paid her advisor an annual 1% fee used to be able to deduct the $10,000 fee from her taxable income, nudging her down a tax bracket and resulting in a tax bill that was thousands of dollars lower.

The ban on deducting advisor fees is in force through the end of 2025, when the 2017 tax cuts are also due to expire. By that time, there will have been eight years for many IRAs to have become slightly smaller, a downward shift that further lowers a plan’s returns in future years.

Say a client today pays a 1% advisor fee for his $1 million IRA directly from the plan, which gains a conservative 6% each year. Over eight years, that plan will grow to nearly $1.6 million, according to a calculator from Ativa, a financial software company. If the fee is yanked out each year, the plan will have under $1.5 million, according to the calculator — $116,393 less, to be precise.

Now say that client instead pays the annual fee out of pocket over eight years, or $80,000. That’s a savings of more than $36,000 compared to paying out of the plan. Now assume the same scenario over 30 years. Paying out of the plan yields an IRA worth just north of $4.3 million, while paying out of pocket leaves the plan with more than $5.7 million. That’s a difference, according to the calculator, of over $1.4 million.

The tax news isn’t all bad, however. One upside to paying out of the IRA is that it can reduce required minimum distributions once the owner reaches age 72. Allowing the IRA to pay its own fees also reduces the balance in the account, which then reduces the required minimum distribution (RMD) when the taxpayer reaches age 72. "Retired investors who do not need their entire RMD to fund living expenses could find this to be a particularly attractive strategy,” says a note from Rodgers & Associates, a fee-only advisory firm in Lancaster, Pennsylvania.

Another potential upside: Older clients whose retirement portfolios are mostly or entirely their IRAs can get not just the equivalent of the deduction, but potentially even more, since there’s no longer an AGI threshold for deducting the fees. “For many well-heeled taxpayers, the equivalent strategy may even be better than the outright deduction," wrote CFP David Robinson, the founder and CEO of RTS Private Wealth Management, an RIA in Phoenix, Arizona.