How to Pay IRA Expenses
How to Pay IRA Expenses
Payment of the
management fees for an IRA presents planning opportunities--and pitfalls.
Question: Clients may have management expenses or fees with respect
to their IRAs. Should these be paid directly from the IRA, or must they be paid
that way? Can fees for multiple different accounts be paid all from one
account?
Answer: Payment of the management fees for an IRA presents planning
opportunities--and pitfalls.
The planning opportunity arises from the following facts: IRS rules provide that management expenses of an IRA may be paid directly from the IRA, and such payment will not be considered a distribution from the IRA for any purpose. Or the IRA owner may alternatively use his outside funds (taxable account) to pay the management expenses of his IRA, and such payment will not be considered a contribution to the account. Thus the IRA owner (or beneficiary, in the case of an inherited IRA) should carefully consider which source of funds is most advantageous. He or she needs to ask: Is my IRA too big (so I should try to shrink it in legal and tax-advantaged ways)? Or is it too small (so I should try to grow it in every legal way possible)?
This is one case in
which size does matter.
Ferdinand
Example: IRA too small. Ferdinand is trying to
maximize the value of his tax-deferred retirement plans. Though he earns
$300,000 a year, he is over 50 and hasn't saved enough for a retirement that is
now just a few years away. He has already made the maximum IRA contribution
allowed for 2013. His investment advisor charges $10,000 a year to manage
Ferdinand's $1 million IRA. If the fee is paid out of the IRA itself, that
diminishes the IRA unnecessarily. By using outside funds to pay the fee,
Ferdinand avoids "wasting" some of the IRA money, keeping his IRA
intact. The account can grow faster, giving him retirement security sooner, if
he uses outside funds to pay the fee. Even though the IRS does not treat this
as a contribution to the account, it functions like an additional contribution
in terms of its financial effect.
Another benefit of
using outside funds is that this type of fee is tax deductible if paid using
outside funds, as an expense for the management of property held for production
of income. However, such "miscellaneous itemized deductions" are
deductible only to the extent the total of such deductible expenses for the
year exceeds 2% of Ferdinand's adjusted gross income, so he will most likely
only get a partial income tax deduction for this management fee, even if it is
all paid from outside funds.
Rhonda
Example: IRA too big. Rhonda is 69 years old
and still working. She has the opposite problem from Ferdinand: Her IRA is too
big. She has a $5 million traditional IRA, incurring a management expense of
$37,500 per year. She refuses to take IRA distributions before she has to, or
to consider Roth conversions as a way to diminish the impact of future required
minimum distributions (RMDs) that will inevitably start flowing out of her IRA
in just a couple of years. Paying the management fee directly from the IRA
itself will help (a little) to diminish the size of those future RMDs, while
paying the fees using outside funds would just increase the income problem she
will soon face.
While it is nice that
this flexibility in the rules allows planners and their clients to achieve
varied goals, it also presents some tricky hurdles and pitfalls:
It's OK for the IRA to pay the expense directly, but not reimburse the expense: Suppose the IRA manager takes his fee directly from the IRA funds he is managing. Can the IRA owner reimburse this amount to the account? No. That would be considered a "regular contribution" to the IRA.
A
Traditional IRA cannot pay management fees for a Roth IRA: Each type of IRA must pay no more than its own properly
allocable share of any management fees. If the IRA owner has both a traditional
and a Roth IRA under management by a professional advisor, it would be nice tax
planning to pay both IRAs' fees out of the traditional account, but you can't
do it. The IRA can pay only its own expenses; if it pays expenses attributable
to some other account (such as a Roth IRA, or the owner's taxable account) that
would be considered a distribution from the traditional IRA (and a contribution
to the Roth, if applicable).
Yes
this can be cumbersome for an asset manager: Joel manages multiple accounts for his client--a
traditional IRA, a Roth IRA, and a taxable account. The simplest way to handle
the combined management fee would be to take it all from the taxable account.
That would be perfectly "legal" and would not be considered a
contribution to the IRA or Roth IRA. But if Joel determines it would be more
advantageous for this client to have the fees paid directly from the IRAs (or
if the client can't afford to pay the fees any other way), Joel will have to do
some homework, apportioning the fee (each quarter if that's how he charges!)
among the three accounts based on their relative values, and collecting a share
of the fee separately from each of the three accounts.
Management
fees only, not transaction expenses: The flexibility to use either plan assets or outside
assets to pay fees applies only to "management expenses," such as an
annual investment management fee (typically based on the amount of assets under
management). Brokerage commissions and other "transaction expenses"
can be paid only out of the transacting account.
Roth
management fees not deductible if paid with outside assets: The owner of a Roth IRA may well wish to maximize its
potential tax-free future growth by paying any applicable management fees for
the account with outside assets--and he is welcome to do so. However, unlike
with a traditional IRA, such payment will not create an income tax-deductible
expense. Expenses incurred for the management of property that generates tax-free income are not deductible.
Resources: See Internal Revenue Code § 212 (deduction for
expenses incurred in managing property held for the production of income) and
§ 67 (limit on deductibility of miscellaneous itemized deductions).
Regarding denial of a deduction for management of a Roth IRA, § 265 denies
a deduction for otherwise-deductible expenses "allocable" to income
that is tax-exempt, or, as the regulations put it, "Wholly excluded from
gross income under any provision of Subtitle A" or any other law. Reg.
§ 1.265-1(b)(1)(i). For confirmation that separately-paid administrative
fees of an IRA may be deductible as miscellaneous itemized deductions, see IRS
Publication 590 (IRAs), 2012, page 12. For the rule that payment of IRA
management fees using outside assets is not considered a contribution to the
account, see Rev. Rul. 84-146, 1984-2 C.B. 61. For the rule that commissions
and similar transaction costs are not considered management expenses, see Rev.
Rul. 86-142, 1986-2 C.B. 60.