The new tax law and investment management fees
A particularly astute reader wrote in to ask about a provision in the new tax law that I didn't write about in my article back in December: specifically, that all "miscellaneous" itemized deductions are now removed, which includes the deduction for investment management fees. They were curious to know if this changes strategies for managed investments, which is an excellent question. Executive summary: no. If that's all you need to know, you can move on. If you need some details, I've got some financial geekery for you.
The way things used to be
First, a quick primer on what the law said back before the Tax Cuts and Jobs Act. Before 2018, there was a raft of what were called "miscellaneous" itemized deductions. This included tax preparation fees, investment management fees, hobby expenses, and other items. Many of these were subject to a 2% threshold: only the amounts of total miscellaneous deductions above 2% of Adjusted Gross Income were deductible. For example, if you paid $1000 in investment management fees and $1000 in tax preparation fees, and your AGI was $50,000, you could tax ($2000-($50,000*2%)=)$1000 in itemized deductions for those fees.
As a side note, financial advisors have always been a little miffed about this. Generally speaking, if you own a business and there is a necessary expense for that business, that expense is fully tax deductible. In fact, it doesn't even count towards your AGI, which would (for example) increase the amount of your 2% deductions, since 2% of your AGI would then be lower than otherwise. As investment portfolios are effectively a business -- their entire purpose is to make money, after all -- then investment management fees are a necessary expense. Shouldn't they then be fully deductible, not "miscellaneous"?
Of course, a 2% miscellaneous deduction is better than none at all, which is the way it is now.
The way things are now
Per the TCJA, all miscellaneous deductions are now temporarily removed, to be brought back as part of the 2025 sunset provision. (Of course, Congress may extend or eliminate the 2025 date; we'll see when the time comes.) This includes both tax preparation fees and investment management fees; they are now completely non-deductible.
However, note that this isn't a particular slam on CPA's, CFA's, CFP's and the like; it's just part of the removal of miscellaneous deductions as a whole. It's entirely possible that Congress will move to bring those back in some form or fashion, once the dust settles (and the Wall Street lobby has a chance to do their thing). Especially since there are some investment management fees that are effectively pre-tax (more on that in a bit).
Also note that it is harder across the board for any itemized deductions to make a difference -- since the standard deduction was doubled and the "SALT" (State And Local Tax, which includes property tax) deduction was capped at $10,000, many households that previously itemized will now find themselves taking the standard deduction.
So -- what about these other investment management fees I mentioned earlier, that have always been (and are still) effectively tax deductible?
First, mutual fund expense ratios are removed from your account pre-tax -- any accumulated dividends go towards those mutual fund expenses first, untaxed, before being paid out to fundholders.
Second, any commissions paid by the mutual fund to a broker (and then passed on to you, in the form of upfront charges on A shares, back-end charges on B shares, or ongoing charges on C shares) are considered mutual fund expenses, and thus paid pre-tax. Now, in this day and age, there's virtually no reason for you to buy anything but no-load mutual funds, but if you do, at least you won't be taxed on the sales commission you're paying.
Third, consider a Traditional IRA. The money goes in tax-free, but is taxed as ordinary income when withdrawn. Any investment management fees (including those charged by a financial advisor) are withdrawn directly from the account, untaxed, and thus by definition are pre-tax.
Which finally brings us to answer the question: what strategies might one undertake in light of the new law? The easiest way to answer is to address each of the above subtleties in turn:
Given that mutual fund expense ratios are pre-tax, larger investment advisory firms are considering institutionalizing their strategies: in short, rather than charging a percentage of AUM (assets under management) to implement a strategy for picking stocks, bonds, and mutual funds, turning their strategy into a mutual fund itself and replacing the AUM fee with an expense ratio. Of course, insofar as they were able to customize portfolios for individual clients, they will no longer be able to, so I'm not sure how common this will be, especially in light of the 2025 sunset provision.
Given that commissions are also pre-tax, some firms may move to a commission model: rather than charging a straight AUM advisory fee of e.g. 1%, they'll find mutual funds with a commission of e.g. 1% and pass that on to the client. This is more difficult than it sounds, however -- finding the right mutual funds with the right commission isn't necessarily easy, becoming a registered representative of a broker-dealer requires jumping through some hoops if you haven't done it already, and (most importantly, in my opinion) if you go from being a fee-only advisor to a commission-paid salesperson, you're going to potentially lose trust with your clients.
Given that fees withdrawn from Traditional IRA's are pre-tax, it makes sense to withdraw any investment management fees directly from them, rather than paying out of a separate account. (Yes, that means that less of the IRA will be growing tax-free, but the break-even point is many, many decades in the future, so it generally makes sense to do so anyway.) However, there are some things to bear in mind on this front; see below.
Some notes on IRA's and investment management fees
It is entirely permissible to pay an IRA's brokerage fees out of a non-tax-advantaged account. (Yes, really, and no, it's not a "deemed contribution" to the IRA. See Private Letter Rulings 201104061, 9005010, and 200507021.) In the case of a Roth IRA, I recommend doing so, for similar reasons that I generally recommend withdrawing from non-tax-advantaged accounts before Roth IRA's in retirement: this allows more of your Roth IRA to grow untaxed, for longer periods of time.
However, it is not permissible to pay another account's investment management fees directly out of an IRA -- only those expenses that are “ordinary and necessary expenses of the retirement account” may be paid directly from it. Potentially, if you were to do so, this could be treated under Internal Revenue Code Section 4975 as a transaction between the account and a "disqualified person", which could have the effect of disqualifying your entire account, causing you to pay taxes on 100% of it immediately!
So if your financial advisor suggests pulling all of your investment fees from your Traditional IRA, applaud their desire to save you on taxes -- and don't let them do it!
Given the above, if you're using a financial advisor, there's a very small chance that they may make a radical change in light of the new tax law; however, chances are high that they won't suddenly become a mutual fund, start charging commissions, or start pulling their fees from your Traditional IRA (insofar as it's permissible, they should have been doing that anyway!).
This article has delved even further into financial geekery than my normal posts do; if you've made it to the end, congratulations! And of course, if you have any questions or thoughts, don't hesitate to leave a comment or send an e-mail.