How to Make Your Fees Part of Clients' Tax Strategy

An advisor may be better off describing their fee as an investment management fee, with fees for planning services either billed separately or provided free of charge.

Tax Rates & Returns

Does it always make sense to take fees from a traditional IRA? Generally yes, but some investors might in fact be better off taking all fees from taxable accounts. This is because the fees that could have been withdrawn from a traditional IRA or 401(k) could have remained in the account growing tax-free over time.

With a long enough time horizon and a high enough rate of return, the funds left in the traditional account could have achieved a higher after-tax return despite starting out with a 30% marginal tax rate disadvantage.

Of course, the higher the investor’s tax rate when they forgo taxes by contributing to a traditional savings account, the bigger the hurdle the investor would need to surmount to break even.

Consider the same worker who pays $1,000 for fees from a traditional account. They could have instead earned $1,429 in a taxable account and paid the $1,000 in after-tax fees. Had they left the $1,000 alone in the traditional account, eventually the tax-deferred growth would exceed the after-tax growth of a taxable investment even at a lower capital gains tax rate.

Levine estimates that at a 23.8% capital gains tax rate, the breakeven for a worker with a 37% marginal income tax would be 26 years at a 8% rate of return and 35 years at a 6% rate of return.

Since returns are unknown, the best strategy for most investors is likely to bill for investment advice for a traditional investment account using funds from the account itself.

“Candidly, even where the fee for a pretax account mathematically makes sense to bill directly from a taxable account, the friction and additional conversations it creates may not make it ‘worth it’ anyway,” notes Levine.

Where to Look First

When deciding which taxable assets to withdraw advisory fees, it makes sense to use the most tax-inefficient investments first. In a recent CE webinar for Kitces.com, I compare the net (after-tax) return of various nonqualified investments including annually taxable (such as bonds and cash) to basis assets (such as long-term stock).

Investors benefit from spending first from the assets with the lowest expected after-tax return, generally those whose gains are taxed annually, and spending last from assets with the highest net return, such as appreciated passive stock funds. Withdrawing investment fees from cash then makes perfect sense.

Annuities also provide a tax-deferral advantage, especially when used to house tax-disadvantaged investments whose gains would otherwise be taxed annually. While investors would normally pay income taxes on funds withdrawn from the annuity, they can pay for advisory fees from annuity growth without being subject to taxation.

Tim Rembowski, vice president at DPL Financial Partners, notes that paying with untaxed growth rather than after-tax dollars is an advantage of investing in a nonqualified annuity. “Now that advisory fees can’t be deducted, paying with tax-deferred dollars from the annuity is a huge benefit to the client.”