Are Your Financial Advisor Fees Tax Deductible?
Taking charge of your finances can be tricky. Even if you are confident and comfortable making your own financial decisions, you cannot be 100% sure that the decisions you make are suited for the financial goals you wish to achieve. However, getting insights from expert financial advisors can help in making sound financial decisions, which can significantly impact your investment returns and long-term financial goals. Working with a financial advisor can help you create a foolproof financial plan and accommodate all critical aspects such as budgeting, saving, debt management, investing, retirement planning, estate management, etc. As per a study, expert financial advice can potentially increase your investment portfolio returns by 3% annually. This has often been referred to as the edge a financial advisor can likely bring to your portfolio. Further, a competent financial advisor not only offers sound financial advice but saves time and reduces money-related stress.
Despite such significant benefits, many people wonder if hiring a financial advisor is worth it. This is a valid question. Typically, a financial planner costs about 1% of your assets under management each year. However, the cost compared with the improvement in returns falls significantly short. Additionally, the peace of mind and improvement in financial well-being adds to the value a financial advisor brings to the table. According to a study, 66% of the survey respondents, who had a financial advisor, specified they were financially secure. Further, 85% of the participants with professional financial support stated their lives were on the right track.
Apart from offering monetary and non-monetary benefits, the money you pay for financial advisory services can help you get tax benefits. So, if you are wondering – ‘Are my financial advisor fees tax deductible? - the answer is a partial yes. Even though rules regarding these advisory fees tax-deductible status have been revised, the tax exemption is still available in a constrained manner. Earlier, until 2017, investment and financial planning services were categorized as miscellaneous itemized deductions. You could get partial or total exemption in your federal income tax return. However, later in 2018, after the Tax Cuts and Jobs Act, some significant changes were made to this taxation aspect, specifying what could and could not be considered as investment advisor fees tax-deductible.
If you want to know if financial planning advice tax-deductible, read this guide to understand the intricacies involved and how you can best benefit from the advisory fees tax deductible option:
Are investment advisory fees deductible?
Before the tax overhaul by the Tax Cuts and Jobs Act 2017, you could deduct the fees you paid to a professional for “investment advice” by classifying them as miscellaneous expenses on Schedule A of your income tax return for the year. These deductions are for expenses, such as:
- Financial advisor fees
- Custodial fees for IRA (Individual Retirement Account)
- Legal and tax-related counsel charges
- Accounting costs
- Trustee fees
To qualify for this advisory fee tax-deductible, you had to show that your miscellaneous itemized deductions were higher than 2% of your annual adjusted gross income (AGI). AGI is your total annual income (including wages, dividends, salaries, bonuses, and capital gains) minus specific deductions, such as personal exemptions and itemized deductions. The IRS (Internal Revenue Service) uses the AGI to determine your yearly tax liability.
For instance, in 2016, if your AGI was $300,000, then miscellaneous expenses (including financial advisor fees and investment-related expenses) over 2% of your AGI or $6,000 were eligible for deduction from AGI. So, if in 2016, you paid $8,000 as fees for financial advisory services, then you could deduct $2,000 from your AGI. That said, you would not get any deduction if your financial advisor fee or related investment expenses were under 2% of your AGI or less than $6,000.
However, with the passage of the Tax Cuts and Jobs Act in 2017, the category of miscellaneous itemized deductions was eliminated effectively from the tax year 2018. This change in the tax code, along with other rules laid down in the act, will remain effective till 2025 unless the government renews it.
How does the new tax code change the investment advisory fees tax deductible status?
Technically, after the removal of the miscellaneous deductions, there are no other specific rules set for the deductibility of financial advisory fees. This means that the remuneration you pay to your financial advisor now falls under the standard deductibility rules. Presently, the IRS gives tax deductions only if you are incurring an expense for earning assessable income. Assessable income is the income that is subject to federal income tax laws.
In general terms, you can claim a tax deduction for the financial advisor fee, provided that the advice is directly concerned with or leads to a specific investment option that generates taxable income. Alternatively, if the money you pay to your financial advisor is for counsel that has no bearing on producing assessable income, then the investment advisory fee is not deductible.
For instance, if you want to hire a professional financial advisor to help you with loan processing for your private residence, then the fees you pay to the expert for their help will not be tax deductible because you are not earning any money from the property you are buying. However, in the same scenario, if you were engaging professional advisory services to get a loan for a commercial property purchase, you could claim a tax deduction for the fees paid to the expert for their help.
Have you lost the chance to benefit from tax deductions?
Even though the passage of the Tax Cuts and Jobs Act can cost you miscellaneous tax deductions, you have not lost the complete benefit. In many instances, the elimination of the tax deductions has had no impact on the income or the tax benefits. Removal of the miscellaneous tax deductions primarily affected investors who paid fees for investment advisory services according to the percentage of their assets invested in non-qualified investment accounts. A non-qualifying investment account does not have any tax benefits like a custodial account, Transfer-on-Death (TOD) account, individual or joint account, etc. Non-qualifying investments are taxed annually.
So, if you are paying your investment advisory fees from qualified plans like an IRA, you have not lost any of the tax-deductible benefits. This is because the advisor fees from an IRA, a 401(k), or similar qualified accounts are paid on a non-taxable basis. Hence, there is no loss of tax benefit when the fees are given from these types of assets. But it is not advisable to pay for investment advisory fees from a Roth IRA because withdrawals from a Roth IRA are not taxed. After all, the original contributions to these accounts are made on an after-tax basis. It is wiser to allow the money in this account to grow tax-free for as long as possible.
Furthermore, there were significant hurdles when it came to claiming the advisory fees tax-deductible; for example, the deduction was available only if your total miscellaneous expenses exceeded 2% of your AIG.
For instance, in 2017, you earned $150,000, had savings worth $1million ($500,000 in qualified accounts and $500,000 in non-qualified accounts), and paid an investment advisory fee of 1%. The investment advisory fee paid from the qualified accounts, such as an IRA, would not be taxable. Hence, there is no requirement to deduct those expenses from your AIG because typically, you are already getting an exemption by not paying taxes on the sum paid from an IRA.
Alternatively, investment advisory fees paid from non-qualified accounts would be deductible in 2017. But you would only have been able to deduct $2,000 ($5,000 - $3,000) from your AIG because of the 2% threshold (2% * $150,000 = $3,000). This is significantly lower than the actual amount $5,000 paid to the professional (1% *$500,000 = $5,000).
That said, irrespective of whether the new tax codes affect you or not, it is critical to be aware of them.
What are the tax deductions available to you as an investor?
Presently, here are some of the deductions that you can claim as a part of the investment advisory fees tax deductible:
- Taxable income: The IRS allows you to deduct the fees you pay to a professional financial advisor for investment counseling and advice, subject to some limitations. You can claim a deduction for expenses if the investments you generate are taxable income. Alternatively, if the securities do not give taxable returns, you cannot get deductions for the fee paid to the advisor. So, if your financial advisor invests your money in tax-exempt municipal bonds, you will not get any tax deductions because the income from these bonds is not taxable. However, when you sell these bonds for a profit in the future, you would be generating taxable income (capital gains). In this situation, you would need to determine the percentage of your financial advisor fees that taxable income generated by the particular investment.
- Travel expenses: If you engage with a financial planner who lives in a different city and you incur travel expenses when going in for a consultation, then you can claim a deduction for the travel expenses incurred for seeking investment advice. In this aspect, travel expenses include transportation and lodging costs like airline tickets, hotel bills, meals, etc. However, traveling for an investment seminar, convention, stockholder’s meetings, etc., does not qualify for a deduction.
- Interest expenses: Even under the new tax regime, interest paid on the money borrowed to buy taxable investments is tax-deductible if you itemize on Schedule A. This includes the interest you pay for margin loans, etc. The maximum deduction you can get is the amount of net taxable investment income for the particular year.
- Investment portfolio costs: The initial fee for establishing an investment portfolio or financial plan is a capital expense and is not deductible. However, recurring fees paid to a financial advisor to maintain the financial plan or portfolio are eligible for a tax deduction, provided the expenditure is related to earning taxable income. If the fee is paid for counsel on the management of private loans or insurance premiums, then only a particular part of the expenditure incurred is deductible. Fees paid for tax advice on investments are also tax-exempt.
- Miscellaneous expenses: Even if you pay a hefty sum as a financial advisory fee, you may not be able to write it off completely. However, you can claim deduction on a specific portion of the fees paid by itemizing your deductions. But itemizing your deductions might not be a wise strategy, especially since the standard deductions have nearly doubled over the last few years. If you have no choice other than itemizing deductions, you can include your investment advisory fees in miscellaneous expenses, subject to the 2% rule. You can only deduct the miscellaneous expenses that exceed 2% of your AIG. Itemizing deductions is a good move if your deductible expenses are above the standard deduction, such as student loan interest, traditional IRA contributions, etc. You can decide between itemizing your expenses or taking the standard deduction by doing some simple calculations. Compare your taxes when you take the standard deduction versus itemized deductions.
How can you reduce your taxable income apart from the advisory fees tax deductible?
The ultimate objective of using the investment advisory fees tax deductible is to lower the taxable income and reduce your tax liability. However, it is also possible to reduce your taxable income by opting for other methods, such as:
- Investing in qualified accounts: Qualified accounts like an IRA, 401(k), or other similar workplace accounts give you the benefit of making tax-deductible contributions. Your contributions to these accounts are exempt from your annual taxable income, lowering your annual tax liability. However, the maximum deduction depends on your income, tax filing status, etc. For instance, in 2023, you can contribute $6,500 to an IRA. If you are above 50 years, you can contribute another $1,000. These contributions reduce your taxable income by that amount consequently, reducing your tax liability. It is wise to maximize your contributions to such qualified accounts and lower your taxes instead of opting for itemized deductions.
- Opting for an HSA: An HSA (Health Savings Account) allows you to make tax-deductible contributions every year according to the upper limit set by the IRS. For 2023, the upper limit for self-only HSA is $3,850, and for family HSA, you can contribute up to $7,750. However, if you are above 55 years of age, you can contribute $1,000 additionally per year above the maximum contribution limit.
- Investing in tax-efficient securities: Making tax-efficient investments can help minimize your tax bill. Even if you have a taxable brokerage account, you can choose securities like ETFs (Exchange Traded Funds) that are more tax-savvy. ETF is a portfolio of securities, such as stocks and bonds, which tracks an underlying index. The ease of buying and selling ETFs coupled with their low transaction costs makes ETFs a tax-efficient investment.
- Diversifying your portfolio: Creating a diversifying portfolio by investing in tax-efficient investments like real estate can also help you lower your tax liability. Investment properties are eligible for depreciation deductions, which can help you reduce and, in some cases, even eliminate taxable income on rental profits. In real estate, depreciation refers to the decline in the property value due to wear and tear, decay, age, etc. This can work for your benefit if you have rental real estate investments. The U.S. tax code grants depreciation deductions for private real estate investors, allowing them to recover some capital invested in real estate to maintain it over time. These deductions are available even if the cash flow from the property is positive. However, there are other complications and eligibility conditions involved in claiming depreciation deductions.
- Holding assets for the long term: Holding assets for a longer investment duration can potentially increase your returns and lower your tax bill in the future. Holding on to investments for a longer tenure helps you take advantage of the more favorable long-term capital gain tax, which is lower than the short-term capital gain tax. If you sell your security within one year of buying it, your gains are taxed as ordinary income. This significantly increases your tax bill by pushing you into the higher tax bracket. Depending on your AIG, the tax rate, in this case, could be as high as 35%. Alternatively, if you would hold securities for longer than one year, your gains would be taxed according to the long-term capital gains tax rate of 20%. Further, if you are in a lower tax bracket, you can even qualify for a 0% long-term capital gains tax rate.
- Deploying tax-loss harvesting strategies: Tax-loss harvesting is a strategy that can minimize your tax liability in a year. This strategy offsets your capital gains with specific investment losses. When you use a tax-loss harvesting strategy, you sell investments (including stocks, bonds, mutual funds, ETFs, etc.) that are in loss to counterbalance any capital gains realized from the sale of other investments. Alternatively, tax-loss harvesting involves replacing loss-bearing investments with similar options to fulfill investment goals and asset allocation strategies. These strategies can minimize taxes in investments. Tax-loss harvesting tactics limit short-term capital gains, allowing you to take advantage of low long-term capital gains tax rates. However, when you use tax-loss harvesting strategies for a taxable account, be careful to adhere to IRS rules like the wash sale rule. As per the wash sale rule, you cannot replace security with a similar one - 30 days before or after selling the asset at a loss.
Even though the current advisory fees tax deductible IRS status is non-deductible, with the expiry of the Taxes Tax Cuts and Jobs Act in 2026, the rules may change, and favorable tax benefits for financial advisory services can likely come into force. Meanwhile, you can take advantage of several other significantly wise tax-saving opportunities. Moreover, with due guidance from a professional financial advisor, you can boost your yearly returns and work effectively to minimize taxes.