Strategies to Minimize Investment Fees in Consideration of New Tax Law

Federal employees who use financial planners to help advise them on how to invest their non-retirement and retirement capital assets (that includes stocks, bonds, mutual funds, ETFs, etc.) should be focusing on how — and how much —  they are paying in investment fees to planners. The recently passed Tax Cuts and Jobs Act of 2017 (TCJA), which took effect Jan. 1, 2018, repealed the tax deduction for investment advisory fees, effectively raising investment fees for millions of investors. This column discusses what affected employees should be focusing on as a result of this change in the tax law.

Before the passage of TCJA, fees paid for investment advice by individual investors could be deducted on the individual investor’s federal income tax return, assuming the individual itemized (filed Schedule A) on the individual’s tax return. The fees paid were deducted as part of one’s “miscellaneous” itemized deductions. Under TCJA, miscellaneous itemized deductions were eliminated from Schedule A and therefore no longer deductible.

The repeal of the deduction could have an adverse effect on those individuals who pay fees for investment advice. The fees paid are a percentage of the assets being managed, typically about 0.5 to 3 percent of the total value of the investment assets under management.

While 0.5 to 3 percent does not appear to be much, consider an investor with an investment portfolio worth 1 million dollars. If the financial planning firm or planner is charging an annual 2 percent investment fee, then the investor is paying an annual investment fee of $20,000 (2 percent of 1 million dollars). Would the $20,000 be deductible pre-TCJA? Yes, but not entirely.

Miscellaneous itemized deductions include investment fees, tax preparation fees, safe deposit box fees, union dues, and employee business expenses, and in total must exceed 2 percent of one’s adjusted gross income (AGI) before being deductible. For example, if an investor had an AGI of $150,000 and $20,000 in investment advisory fees, then two percent of $150,000 is $3,000. That would mean $17,000 of the $20,000 fee would be included as part of miscellaneous itemized deductions.

Another hitch under pre-TCJA that limited or disallowed this deduction affected individuals who owed the alternative minimum tax (AMT). The result was that these individuals who were high earners and owed the AMT often did not benefit from including advisory fees as part of miscellaneous itemized deductions because the latter was not used in calculating the AMT. Nevertheless, many investors will feel the loss of the deduction.

The fact is that in recent years, financial planning firms, brokerages and financial planners have pushed their clients toward fee-based rather than commission-based accounts. According to consulting group Aite Group, during the period 2010 to 2016 the total amount of investment assets held in fee-based accounts nearly doubled from $4.1 trillion to $7.9 trillion. Typical investment fees paid are a percentage of the investment assets being managed, ranging from 0.6 percent to 2 percent annually, with many investors paying 1 to 1.5 percent on accounts of less than $1.5 million.

With more and more investors owning fee-based investment accounts, there are things that federal employees should do and be aware of in order to not pay more than they should when it comes to investment advice and fees, both with their retirement and with their non-retirement accounts. The following are some suggestions:

• Understand and know the fees being paid for investment advice. A 2017 survey by Cerulla Associates found that 49 percent of investors did not know what they paid for when it comes to investment advice or worse, thought the investment advice was free.

• Understand the effect of TCJA on advisory fees and taxes. Until the passage of TCJA, advisory fees could be deductible as part of one’s “miscellaneous” itemized deductions. That is no longer the case with TCJA’s passage. Commissions to buy investments held in retirement accounts are not tax deductible. However, commissions may reduce potential capital gains taxes as a result of increasing an investor’s “cost basis” in the capital asset, which is the starting point for measuring taxable capital gains when an investment is sold.

• Understand the effect of advisory fees on investment returns. Advisory fees are typically quoted as a percent of the investment assets being managed, which can make them seem smaller than they really are. The advisory fees should instead be interpreted as how they affect the annual investment return of the assets. This is because the advisory fee percentage fee percentage is deducted from the gross investment return, resulting in the “net” investment return. For example, if the advisory fees are 2 percent of the investment assets being managed and the gross investment is 6 percent, then the “net” investment return is 4 percent. A financial advisor or planner should be asked if the reported annual investment returns include the effect of the advisory fee percentage.

• Consider the alternatives for paying investment or other fees. With respect to investments held in non-retirement brokerage accounts, investors paying higher fees than they should be paying are encouraged to consider switching to lower cost investments, or look for investment vehicles that are more tax efficient. With respect to IRA investments, IRA owners may want to consider paying for advice using assets inside the IRA. Given the new tax with nondeductibility of IRA advisory fees, it may make sense to pay the IRA advisory fees from within the IRA using before-taxed dollars. The problem with using before-taxed dollars is that in so doing, the tax-deferred growth of the assets used to pay the fees is permanently lost. A $100 fee paid each year that may be earning, for example, 7 percent over time if it were not withdrawn, could lead to substantial growth over time, as the following table illustrates:

In analyzing the table, it is obvious that paying a $100 a year investment fee for an IRA can over time lead to significant decrease in the IRA account balance. Over a 30 year period, the IRA could forfeit $10,000 in value, while over 40 years the IRA could forfeit nearly $21,500. Thrift Savings Plan (TSP) participants should keep this in mind when contemplating the rollover of some of their TSP accounts – which have the lowest investment fees in the industry – to a “rollover” IRA, usually at the suggestion or urging of a financial planner or brokerage firm who have much to gain by taking charge of the TSP participant’s account.