In a year like 2015, when equity indexes such as the S&P 500 and Russell 2000 have provided the slimmest of returns, advisers and their clients are especially aware of any kind of drag on investment performance. Naturally, investors eventually will look at the expenses paid to his/her adviser. Good advisers can justify their expense based on the added value they provide, but being able to explain the tax advantages of those expenses may help even the most fee-sensitive client.
A basic tenet of tax law is that expenses paid to generate taxable income are tax-deductible. However, the method of deducting those expenses and the tax benefit of that deduction vary considerably based on the type of expense paid.
Commissions add to the cost of each transaction
The fees paid by investors generally fall into two categories: commissions or fees. Commissions have long been the standard for how advisers are paid, and that pricing model is still very prevalent today. Every time an investor buys something in his/her account, he/she pays an additional cost — typically a charge based on the number of shares purchased. When that investment is later sold, a portion of the sales proceeds are paid to the adviser, again typically a per-share fee.
Commissions paid to purchase an investment are added to the cost basis of the investment, so purchasing 100 shares of stock for $10 each plus a $0.10 commission per share would result in a total cost of $1,010. If those shares are later sold for $15 each, and another $0.10 per share commission is paid, the net sales proceeds would be $1,490.
For tax purposes, the gain on that investment is the difference between the total purchase price and net sales proceeds, or $480, even though the stock itself increased in value by $500. In this case, the commissions paid reduced the taxable gain and therefore the capital gains tax paid by the investor.
Asset-based fees are trickier to deduct
The trend for many years has been for advisers to charge their clients a fee based on a percentage of the value of the account. Because the fee typically has no correlation to the number of transactions, it can't be assigned to a specific investment and treated as part of the purchase price.
Instead, these expenses fall into a category known as miscellaneous itemized deductions, which also includes items such as unreimbursed business expenses, tax preparation fees and union dues. All these expenses are combined together, and in total must exceed 2% of adjusted gross income before there is any tax benefit. For example, assume a taxpayer has AGI of $200,000 and total miscellaneous deductions of $5,000. Their 2% floor is $4,000 and only the expense amount over that floor is deductible — $1,000 in this case. The other $4,000 in expenses are lost and cannot be carried over into a future year.
Which is better?
Saying which pricing model is better for tax purposes is difficult to discern. Unlike commissions, which provide a definite tax benefit in the form of a reduced capital gain, the tax benefit of investment fees is much more uncertain. High-income taxpayers may find it difficult to exceed the 2% of AGI floor, and therefore do not receive any tax benefit for the fees they pay. Even those whose total miscellaneous deductions exceed the AGI floor may run into another hurdle — alternative minimum tax. The AMT rules do not allow a deduction for these expenses, so an investor that is close to or in the AMT will not receive a tax benefit at all.
On the other hand, investment fees are deductible in the year they're paid, whereas commissions only provide a tax benefit when the investment is eventually sold — potentially many years after the purchase commission is paid. Also, any miscellaneous deductions over the AGI floor are first used to offset ordinary income, not capital gains. This means the tax benefit could be as large as 39.6%, the top tax rate on ordinary income, rather than the 23.8% top rate on long-term gains.
Ultimately, advisers need to create a pricing model that best reflects the type of business they run and the services they provide. The tax treatment of the fees they charge should be just one of the factors they consider.
Tim Steffen is director of financial planning for Robert W. Baird & Co. Follow him on Twitter .