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Maximizing Clients’ Income Tax Savings: Deducting Your Fee

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As the tax filing deadline approaches, we will be discussing tax-planning tips and other tax related issues. In this post, we will outline a process to determine which account(s) should bear advisory fees by calculating the method that yields the greatest income tax benefit for the client. Hence, if you are a fee-based or fee-only advisor, this information will provide you with a process to guide you in your fee deductions. 

IRS Rules on Deducting Advisory Fees

1)      IRA fees may be deducted from a taxable account (i.e., joint or single).

2)      Fees on a taxable account may not be deducted from an IRA.

3)      Fees deducted from an IRA are not tax deductible on IRS Form 1040; Schedule A (i.e., itemized deductions).

4)      Advisory fees are a Tier II deduction and as such, are deducted on IRS Form 1040, Schedule A. The aggregate of Tier II deductions are deductible to the extent they exceed 2% of the taxpayers AGI.

5)      This is not an IRS rule or law, but it’s best not to deduct Roth IRA fees from a Roth account. Making fewer fee deductions from a Roth will result in greater earnings that will eventually be withdrawn tax-free.

Here is an example to illustrate the process of determining the most tax beneficial method of deducting advisory fees.

Basic Assumptions

  • Client: Husband and Wife
  • Annual Advisory Fee %: 0.65%
  • Assets Under Management:
  • Joint Account: $1,000,000
  • Husband’s IRA: $400,000
  • Wife’s IRA: $250,000
  • Total Assets: $1,650,000
  • Fees by Account (FMV x 0.65%)
  • Joint Account: $6,500
  • Husband’s IRA: $2,600
  • Wife’s IRA: $1,625
  • Total Fee: $10,725
  • Taxpayer’s AGI: $350,000
  • Schedule A, Tier II Deduction Threshold: $7,000 ($350,000 x 2%)
  • Advisory fees are the clients only Tier II deductible item
  • Marginal Tax Bracket: 35%
  • Effective Tax Bracket: 29%

Scenario Description

A)     Deduct advisory fees from the applicable account

B)      Deduct all fees from joint account

Scenario A

In this scenario, each account bears its own fee. Because the fee on the joint account ($6,500) is less than 2% of their AGI ($7,000), and because fees deducted from an IRA are not deductible on IRS Form 1040, Schedule A, no income tax deduction is allowed.

However, there is an inherent tax benefit since fees deducted from an IRA are not subject to income tax. Thus, the tax benefit is as follows:

Total IRA Fees x Effective Tax Bracket = Tax Benefit

or

$4,225 x 29% = $1,225

Scenario B

In this scenario, all fees are deducted from the joint account. Because their total fees are greater than 2% of their AGI, a partial deduction is available. Here are the numbers:

{Total Fees – 2% of AGI = Amount Eligible for Deduction} x Effective Tax Bracket

or

{$10,725 – $7,000 = $3,725} x 29% = $1,080

Scenario A provides a tax benefit of $1,225, while the benefit from Scenario B is $1,080. Thus, the greater tax benefit is derived from Scenario A. If you replace the client’s effective tax bracket with their marginal tax bracket, the numbers will change, but the best option will not. If a client does not file a Schedule A, their IRA fees should be deducted from the IRA account (except the Roth IRA as noted above). Upon retirement, if their income declines, deducting fees from their joint account may be the best option.

Next week, we will discuss the Obamacare Shared Responsibility Payment levied on taxpayers who elect not to maintain health insurance. This penalty can be significant, so stay tuned.

Until next time, thanks for reading and have a great week.

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See ThinkAdvisor’s complete tax planning lineup on our 23 Days of Tax Planning Advice: 2016 home page.