Now is the time to refocus on how you pay your investment fees.
In a little-noticed move, the recent
tax overhaul repealed a deduction for investment-advisory fees that effectively
will raise these fees for millions of investors.
Before the overhaul, fees paid for investment advice could be deductible
as “miscellaneous” expenses on Schedule A of the tax return. Now, they aren’t
deductible at all.
The repeal of the deduction affects many investors who pay fees for
advice based on a percentage of their assets, including many with tax-efficient
separately managed accounts.
It also puts pressure on investors in hedge funds and other funds
organized as partnerships, says Robert Gordon, a tax strategist who heads
Twenty-First Securities. That is because they typically owe tax on profits
before hefty fees are deducted, while investors in mutual funds and
exchange-traded funds are taxed on profits after fees.
To be sure, there were hitches to getting the tax break. One was that
expenses were only deductible to the extent that they—together with a grab bag
of other write-offs—exceeded 2% of a filer’s income.
For example, say that two retirees had income of $150,000, savings of $3
million, and an adviser’s fee of 1% that they paid with funds outside their
tax-sheltered retirement accounts. In 2017, they could deduct $27,000 of the
$30,000 fee because of the 2% threshold. For 2018, they will get no deduction.
Another hitch limited or disallowed this deduction for filers who owed
alternative minimum tax. As a result, says Tim Steffen, a tax specialist with
Robert W. Baird & Co., investors who were high earners or owed AMT often
didn’t benefit from the write-off.
Still, many investors will feel its loss.
In recent years, brokerage firms and registered investment advisers have
nudged clients toward fee-based accounts rather than commission-based accounts.
From 2010 to 2016, the percentage of total investment assets in such accounts
climbed to nearly 39% from just more than 30%. The dollars in them have nearly
doubled during the same period, to $7.9 trillion from $4.1 trillion, according
the latest data from Aite Group.
Many investors affected by the recent tax change have accounts with fees
based on a percentage of assets. Typical fees range from 0.6% to 2% annually,
with many paying 1% to 1.5% on accounts less than $1.5 million, according to
Cerulli Associates. The fee is often in addition to those for individual
holdings, such as mutual funds or exchange-traded funds.
With more investors owning fee-based accounts, what is there to do? Here
are a few steps.
Know your fees. A 2017 survey by Cerulli found that more than 40%
of investors didn’t know what they paid for advice or else thought it was free.
A good place to look for information is past 1099 tax forms for
investment accounts that summarize income such as capital gains and dividends.
Firms often listed advisory fees that were deductible on this form, although
the IRS doesn’t require it. These fees also often are disclosed on monthly,
quarterly or annual statements. If they aren’t, ask why.
Also check out fees that aren’t for advice, such as those for the
investment management of mutual funds or ETFs.
Be aware of tax nuances. There are many. Until 2018, advisory fees
could be deductible—but not if paid with assets in an Individual Retirement
Commissions to buy investments in taxable accounts aren’t tax
deductible. But they do reduce taxes by raising the investor’s “cost basis,”
the starting point for measuring taxable gain when an investment is sold.
Interest on money borrowed to make an investment has been and remains
deductible, up to the amount of investment income.
Gauge the fees’ effects. Fees typically are quoted as a percent of
assets, which can make them seem smaller. Instead, think of them as a percent
of annual return. If an investor’s annual fees are 2% of assets, that is
one-third of an annual return of 6%. Ask your adviser if reported returns are
before or after fees.
Consider your options. If you got a deduction for fees in the past,
see what losing it means to you. Advisory fees often are negotiable.
If your fees are high and eroding your returns, investigate switching to
lower cost investments or look for investment vehicles that are more tax
If you have a traditional Individual Retirement Account, consider
whether to pay for advice using assets inside or outside the account.
As you can’t take a deduction, it could make sense to pay the IRA’s
advisory fees from inside the account using pretax dollars—but you’ll also give
up tax-deferred growth on those dollars. The right answer differs from case to
case, Mr. Steffen says.
Corrections & Amplifications
Dollars in investment accounts nearly doubled between 2010 and 2016, to $7.9
trllion from $4.1 trillion, according to the latest data from Aite Group. An
earlier version of this article incorrectly stated the figures in billions.
(May 4, 2018)