Setting up billing in PortfolioCenter requires several “policy” decisions. If you decide to deduct fees from your clients accounts, you need to decide whether to deduct the total fee for a client household from a single account OR deduct a percentage of the fee from each account in the client household (allocation).
If you decide to allocate, from which account(s) should you deduct fees?
Investment management fees are a tax-deductible expense. They can be listed on Schedule A under the section “Job Expenses and Certain Miscellaneous Deductions.” Line 23 includes investment expenses and other qualifying expenses. After all of these miscellaneous deductions are totaled, you can only receive a tax deduction for the amount that exceeds 2% of your adjusted gross income (AGI). If your cumulative expenses are under 2% of AGI, you will not get a deduction. For most working clients, their miscellaneous deductions fall far short of the 2% AGI threshold. Retired clients are more likely to qualify.
If your clients cannot deduct investment management fees directly, they may still pay a portion of the fee with pre-tax dollars, since investment management fees can be deducted from the accounts for which they were charged. For traditional IRAs, the fee is not considered a withdrawal and therefore is not a taxable event. Since your client is paying the fee with pre-tax dollars, the cost is discounted to client by his marginal tax rate.
While I’ve seen advisors take their entire management fee from IRA accounts, I don’t think that is warranted by the letter or the spirit of the tax code; any fee taken from an IRA account should be justified as a fee for the management of a pre-tax account. However, I am NOT a tax expert and I recommend you consult a tax professional to ensure you give the best advice to your clients.
Your clients will see no advantage in paying the entire fee from a taxable account in an attempt to boost their deductions. If you pay $2,500 in management fees, it is better to pay $1,000 from an IRA with pre-tax dollars than to pay for it separately to get a $500 tax deduction. Any amount paid from an IRA is equivalent to getting that same amount as a tax deduction.
Although getting money out of a traditional IRA tax free is an advantage, deducting management fees from a Roth IRA is not. There are limits on getting money into a Roth account where it will never be taxed again. Some managers deduct the portion of management fees prorated to a Roth account from a taxable account. This allows as much money as possible to stay in your client’s Roth and grow unimpeded.
No one likes paying fees. But knowing there are tax-efficient ways to pay management fees may help ease the pain.