Congress Considers Investment Fee Deduction: What's The Verdict?

The Tax Cuts and Jobs Act (TCJA) of 2017 eliminated the ability of individuals to deduct investment-related expenses, including financial advisor fees, custodial fees for IRAs, and legal and tax advice fees. However, there is a possibility that Congress may intervene to restore the deduction, as it was likely an unintended consequence of the legislation. The TCJA is set to expire in 2025, so the current tax cuts may be temporary, and the deductibility of investment fees may be reinstated.

Investment management fees

Prior to the Tax Cuts and Jobs Act (TCJA) of 2017, investment management fees were tax-deductible as miscellaneous itemized deductions. However, the TCJA eliminated the deductibility of most portfolio fees, including investment management fees. This change is set to last until 2025, after which the tax cuts may be reversed or renewed. As a result, investment management fees are currently not tax-deductible.

Despite this, there are still a few ways that investors can reduce their tax liability on investment management fees. One way is to pay financial advisory fees directly from an IRA or other pre-tax retirement account. Since these accounts are tax-deductible, paying the fees from them can result in tax savings. Additionally, investors can look into other tax-efficient strategies, such as investing in tax-efficient assets, utilizing tax-loss harvesting, and minimizing investment management fees by choosing passive investment strategies or negotiating fees.

Investment interest expenses

The Tax Cuts and Jobs Act (TCJA) of 2017 eliminated the ability of individuals to deduct investment interest expenses. However, there are still a few ways that investors can reduce taxes on investment-related spending.

One way to reduce taxes on investment-related spending is to borrow funds to buy assets and claim the interest in their tax returns as an investment interest expense. The deductible amount is capped at the taxpayer's net investment income for the year. Any leftover interest expense can be carried over to the succeeding year.

Another strategy is to treat qualified dividends as ordinary income, which can increase the taxpayer's investment interest expense deduction and reduce the tax they pay to up to 0%.

Additionally, investors can use capital losses to offset their capital gains by selling underperforming assets. This process is called tax-loss harvesting, and individual investors can deduct up to $3,000 in capital losses from their ordinary income each year.

It's important to note that these strategies have specific conditions and limitations, and it's always recommended to consult with a tax professional for personalized advice.

Capital losses

There are three types of capital losses: realized losses, unrealized losses, and recognizable losses. Realized losses occur on the actual sale of the asset or investment. Unrealized losses are not reported. Recognizable losses are the amount of a loss that can be declared in a given year.

Any loss can be netted against any capital gain realized in the same tax year, but only $3,000 of capital loss can be deducted against earned or other types of income in the year. Remaining capital losses can then be deducted in future years up to $3,000 a year, or a capital gain can be used to offset the remaining carry-forward amount.

For example, if an investor has a capital gain of $10,000 and a capital loss of $30,000, they can net $10,000 of their loss against their gain. They can then deduct an additional $3,000 of loss against their other income for that year. The remaining $17,000 of loss can be deducted in future years, in increments of $3,000 per year, until the entire amount has been deducted.

It is important to note that capital losses must be reported on items that are intended to increase in value and do not apply to items used for personal use, such as automobiles. Additionally, losses experienced in a tax-advantaged retirement account, such as a 401(k) or IRA, are generally not deductible.

To claim capital losses on your tax return, you will need to file all transactions on Schedule D of Form 1040, Capital Gains and Losses. You may also need to file Form 8949, Sales and Other Disposition of Capital Assets.

Financial advisory fees

The Tax Cuts and Jobs Act (TCJA) of 2017 eliminated the ability of individuals to deduct Section 212 expenses, which includes financial advisory fees. This change is set to last until 2025, when the act will sunset, and Congress will decide whether to extend or revise it or restore the previous tax regime.

The TCJA has brought about a notable shift in the tax treatment of advisory fees compared to commissions. Commissions are now effectively treated as a pre-tax expense for the investor, while advisory fees are not tax-deductible. This is significant because, previously, fees for investment advice were deductible as a Section 212 expense.

Despite this, there are still some ways to minimise the tax burden of financial advisory fees. Firstly, investors who own an IRA can choose to pay financial planning or investment management fees directly out of the account being managed. Since the fees are considered investment expenses, they are paid on a pre-tax basis, allowing investors to avoid paying income tax. However, investors can only pay the percentage of the fee that is linked to the IRA.

Another option is to switch from advisory fees to commissions. For financial advisors who are able to offer this, it may be appealing to tax-sensitive clients to use commission-based trail products. However, it's important to note that this option may not always be feasible, especially for independent RIAs with no access to commission-based products.

For very large advisory firms, another strategy could be to turn their investment strategies for clients into a pooled mutual fund or ETF. In this scenario, the firm's investment management fee would be deductible, whereas their advisory fee is not. However, this approach has several significant caveats, including the loss of the ability to customise client portfolios and the non-trivial costs involved in creating a mutual fund or ETF.

Finally, for those who don't want to or can't switch to commission-based accounts or launch their own proprietary funds, the most straightforward way to handle the loss of tax deductibility is to pay advisory fees from pre-tax retirement accounts where possible.

Investment advisory fees

The Tax Cuts and Jobs Act (TCJA) of 2017 eliminated the ability of individuals to deduct investment advisory fees as Section 212 expenses, as part of "temporarily" suspending all miscellaneous itemized deductions through 2025. This change in tax law affects investors with substantial holdings in taxable accounts, as they can no longer reduce their taxable income by the amount of advisory fees paid.

Prior to the TCJA, investment advisory fees were considered miscellaneous deductions if they exceeded 2% of a taxpayer's adjusted gross income (AGI). For example, if a taxpayer had an AGI of $250,000 and paid $6,500 in investment advisory fees during the tax year, the exceeding $1,500 (above the 2% threshold of $5,000) would have qualified for a tax break.

With the TCJA in effect, investment advisory fees are no longer deductible, regardless of whether the taxpayer is subject to the alternative minimum tax (AMT). This change disproportionately affects taxpayers with large holdings in taxable accounts, as they can no longer reduce their taxable income by the amount of advisory fees paid.

It is important to note that the TCJA is set to expire in 2025, and there is a chance that the tax cuts may be renewed for another term. If the TCJA is not renewed, the tax deductibility of investment advisory fees may be reinstated, restoring the previous tax treatment.

In the meantime, there are a few strategies that investors can use to mitigate the impact of non-deductible investment advisory fees:

• Paying fees from tax-advantaged accounts: Investment advisory fees paid from traditional IRAs or other pre-tax retirement accounts are implicitly tax-deductible since the account itself is pre-tax. However, it is important to ensure that the fees are only paid for the percentage of the fee linked to the IRA, as fees paid from Roth-style accounts are not tax-deductible.
• Switching to commission-based accounts: For dual-registered or hybrid advisors, there may be an incentive to shift tax-sensitive clients to commission-based accounts, as these commissions are treated as pre-tax expenses. However, this approach may not be feasible for independent RIAs without access to commission-based products.
• Creating a proprietary mutual fund or ETF: Large advisory firms may consider turning their investment strategies into a pooled mutual fund or ETF, allowing them to collect advisory fees as a pre-tax expense ratio of the fund. However, this approach has significant caveats, including client psychology, loss of customization, and implementation challenges.
• Maximizing other tax-deductible expenses: While investment advisory fees are not currently deductible, there are other investment-related expenses that remain eligible for tax breaks. These include investment interest expenses, qualified dividends, tax-loss harvesting, and certain financial advisory fees paid directly from an IRA.

While the future of the TCJA beyond 2025 is uncertain, the current tax treatment of investment advisory fees has created a compelling tax planning strategy for financial advisors and their clients. By understanding the available options and carefully considering their specific situations, investors can minimize the impact of non-deductible advisory fees on their taxable income.

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