Financial Services

Investors can enjoy a tax savings on advisor fees by using this strategy

When investors sit down with their financial advisor to prepare their tax returns next year, they’ll be confronted with new rules that for many mean an increase in the cost of having an advisor.

The new tax law passed by Congress last year ends deductions on some types of advisory fees, including those based on the value of assets under management (AUM), a common way advisors charge clients.

For both the client and advisor, this change is causing quite a bit of angst. Yet much of this worry is needless because many clients can still get a tax savings on some fees by using an equivalent strategy.

The IRS has long held that qualified retirement accounts, such as traditional and other types of individual retirement accounts, can pay their own expenses. As funds in these accounts are tax-deferred, there are no tax consequences to using this money to pay advisory fees related to the management of these accounts.

More from FA Playbook:
Amid heightened equity volatility, what’s an investor to do?
Think before following a broker who leaves their firm
Keep emotions under control when investing

(Money taken out of these accounts usually triggers ordinary income tax and, for those under age 59½, a hurtful 10 percent penalty — but not in this case, because the IRS doesn’t consider these payments to be distributions.)

To the extent that an individual’s assets are in a traditional IRA, IRA rollover or other tax-deferred account (including Simplified Employee Pension IRAs or pension plans) and are under an advisor’s care, you can pay the advisor the proportionate amount of fees directly out of these accounts with pretax dollars.

This strategy serves as an effective tax deduction. Roth IRAs are funded with post-tax income, so there’s no tax advantage to paying advisory fees out of these accounts. This merely diminishes retirement assets, so it’s usually best to pay Roth fees out of a taxable account.

This alternative strategy has long been available, but many weren’t aware of it because advisory clients were happy to get the deduction on AUM fees, often about 1 percent annually. Now that this straight-out deduction is gone, advisors are receiving calls from nervous clients who say they can no longer afford their services, and advisors are alerting them to the alternative strategy. Investors who want to take this route should talk to their advisors about it.

Many Americans have a significant portion of their assets in tax-deferred, employer-sponsored retirement plans, including 401(k) plans, 403(b) plans for teachers and pension plans. Their portion of advisory fees and other expenses is often taken directly from their accounts, so these account holders are already getting the effective deduction.


Leave a Reply