Staying with our tax planning theme during the month of March (see the 22 Days of Tax Planning Advice: 2015 home page), in this posting we’ll discuss the tax ramifications of advisory fees and the types of accounts from which they may be deducted. 

A client may deduct financial planning and asset management fees only if they itemized deductions on Schedule A of IRS Form 1040. Moreover, these fees are deductible only to the extent that they, plus other miscellaneous fees and expenses, exceed 2% of the clients AGI. These fees and expenses are known as Tier II deductions.

Here is a list of the most common fees and expenses that fall into this category. They are entered on lines 21-23 of Schedule A. 

Line 21 – Unreimbursed Employee Expenses (ex: business travel and education, union dues, etc.)

Line 22 – Tax Preparation Fees

Line 23 – Certain Legal and Accounting Fees, Custodial Fees (ex: trust accounts), Investment Expenses of a Regulated Investment Company, Certain Casualty and Theft Losses of Property, Safe Deposit Box, etc. 

Investment advisory fees are listed on line 23. This is not a complete list, but rather the most common items. If the aggregate of these fees and expenses is less than 2% of the client’s AGI, no deduction is allowed. If these items exceed 2% of the clients AGI, then the deduction is limited to the amount which exceeds this threshold.

Therefore, if the client is not allowed a tax deduction, or if the deduction is small, it may be better to change the accounts from which these fees are deducted. But be careful, as the IRS has some well codified rules to consider. 

Account Deductibility Rules

Are there restrictions pertaining to the type of account from which fees may be deducted? To explain, let’s assume we have a husband and wife, each has an IRA, and together they have a joint taxable account. Should each account pay its own fee? Should all fees come from the taxable account? Can the fee from a taxable account be deducted from an IRA? Let’s consider these one at a time. 

First, and most obvious, each account could be responsible for its own fee. Almost as obvious is that all fees may be paid from the taxable account. But what if the client will not receive a deduction for the fees because their AGI is too high? Can all fees be deducted from one or both IRA’s?

Although some advisors may be doing this, it is not permitted by the tax code. Deducting financial planning fees or fees from a taxable account from an IRA runs afoul of the prohibited transaction rule.

In this case, the IRA owner could be subject to a penalty tax of up to 100% of the distribution. The entire IRA could also be disqualified.

In short, this would create a potentially large tax bill since the IRA would be taxed as though the entire balance was distributed. 

Conclusion

If your client itemizes on Schedule A and is able to claim an income tax deduction for Tier II fees and expenses, it may be best to deduct all fees from their taxable account. However, if no deduction is forthcoming because the client’s income is too high, then it’s best to deduct the IRA fees from the IRA and the taxable account fees from the taxable account.

Remember, never deduct taxable account fees from the IRA as this could cause the entire IRA to be disqualified.

See additional Mike Patton tax planning articles:

Your Tax Planning Role When Clients Move to Another State 

Under the Hood: Tax Treatment of ETFs vs. Mutual Funds

See the 22 Days of Tax Planning Advice: 2015 home page.