The recent tax overhaul has repealed the deduction for investment-advisory fees and effectively will eliminate your ability to deduct them. This will effect not only the tax return of investors but also their net investment returns after fees.
So, what does this all mean?
Before the tax code change, you could deduct fees paid for investment advice as “miscellaneous” expenses on Schedule A of your tax return. The new tax code affects many investors who pay fees for advice based on a percentage of their assets in non-qualified investment accounts. The fees paid for investment advice in qualified plans such as an IRA are paid from the account on a non-taxable basis, so there is no loss of tax benefit for the fees paid from these types of assets, only non-qualified accounts, such as Individual, Joint, TOD and Custodial accounts.
First of all, there were hindrances to getting the tax break anyway. One was that expenses were only deductible to the extent that they—together with all your other miscellaneous deductions (if you had any)—exceeded 2% of a filer’s income. For example, say that two retirees had income of $150,000, savings of $1 million in non-qualified accounts, and an adviser’s fee of 1%. In 2017, they could deduct $7,000 of the $10,000 fee because of the 2% threshold. For 2018, they will get no deduction. See our blog post on tax diversification for more.
But in the real world, if you did what most advisors and the IRS have trained you to do; you have a good portion of this $1 million in IRA, 401(k) or other qualified accounts. So, let’s say you had $500,000 in qualified or IRA accounts and $500,000 in non-qualified accounts, here is how you would be affected. The investment advisory fees paid from the IRA accounts would not be taxable and therefor no need to deduct them, since in essence you are already getting a deduction by not having to pay taxes on those amounts used to pay fees from the IRA. The other $500,000 in your joint investment account, in which you paid $5,000 in fees, would however have been deductible. You would have paid $5,000 in fees and been able to deduct $2,000 based on the 2% threshold. Thus saving $560 in taxes and I would say that isn’t a sky falling event for this couple. However, many Americans will be affected by this tax law change and should be aware of it.
With the sentiment in the Financial Services Industry moving toward requiring more advisors to uphold a fiduciary standard in working with and recommending investment products to clients, more and more investors will own fee-based accounts, what is there to do?
Here are a few steps
First, find an Independent Registered Investment Advisor and work with them. They are already held to a fiduciary standard and are making decisions that are in the best interest of their clients. Be sure you chose one whose client’s pay them an investment advisory fee and they do not receive compensation from the investment products they recommend. Then there is never a conflict of interest and you know your best interest will always be first on their mind.
Know your fees
Astonishingly, A 2017 survey by Cerulli found that more than 40% of investors didn’t know what they paid for advice or else thought it was free. They were not aware of how their advisor was compensated or where the money came from.
According to abetterwaytoretire.com, "A good place to look for information is past 1099 tax forms for investment accounts that summarize income such as capital gains and dividends. Firms often listed advisory fees that were deductible on this form, although the IRS doesn’t require it. These fees also often are disclosed on monthly, quarterly or annual statements. If they aren’t, ask why. Also check out fees that aren’t for advice, such as those for the investment management of mutual funds or ETFs." With many advisors today, there is hidden compensation from these sources that should always be disclosed but in many cases is not, or they are buried so far into the fine print that an investor wouldn't see them.
How to figure out the effects of these fees?
Fees are generally quoted as a percent of assets, which can make them appear more digestible. But instead, investors should think of them as a percent of annual return. For example, if an investor’s annual fees are 2% of assets, that is one-third of an annual return of 6%. It may be a good idea to ask your advisor to report your investment returns on a net of fees basis, this way you know what you get to keep after you have paid them for their services and advice.
If you took a deduction for fees in the past, talk to a Registered Independent Advisor and your tax accountant to access what losing this deduction might mean for you and find out if changing your investment vehicles will help. Remember that advisory fees are often negotiable. It's a good idea to look at the fees you are paying at least annually to find out if high fees are eating away at your return on investment.
The right answer is never the same for each investor and differs from case to case.