If you’re like most investors, you’re smartly looking for every tax break available to you without having to search out and understand the entire IRS tax code.
Especially for young adults who are new to the idea of even filing a tax return, let alone understanding some of the tax tips for reducing their taxable income. It can be a daunting learning process, but an important part of your financial journey.
Financial Planning Fees – Are They Tax Deductible?
First, the bad news. Before the Tax Cuts and Jobs Act took effect in 2018, you were allowed to reduce your taxable income for miscellaneous itemized deductions. Those miscellaneous deductions included:
- Financial advisor fees
- Custodial fees paid to IRA accounts
- Accounting costs
- Fees for legal and tax advice
- Trustee fees
To qualify for this tax break, taxpayers had to show miscellaneous itemized deductions greater than 2% of their adjusted gross income for the year. Note that only the amount greater than the 2% could be deducted.
While this change is scheduled to remain in effect through the 2025 tax year, it is possible that the tax code could be changed and the deduction reinstated after the 2025 tax year.
The Benefits of Using a Financial Planner
All of this brings us back to the question of why a financial planner might be of benefit in the first place.
Financial advisors can help you shape a financial plan when it comes to things like budgeting, saving and investing in a way that’s unique to your needs and wants.
Benefit 1: Emotional Guardrails
A good advisor will help protect you from using emotions and biases to make rash decisions that may not be in your best interest.
Benefit 2: A Comprehensive Plan
An advisor can help you develop a plan that considers factors you might not be considering. For instance, have you considered tax planning? Have you thought about a budget plan or inflation rates that impact how far your retirement income will go?
Benefit 3: A Champion For Your Success
Budgeting, saving, investing and minimizing your tax liability are perhaps the most important things you can plan for, so wouldn’t it be nice to have an objective expert who is truly looking out for your best interests?
Do Any of My Investment Expenses Qualify for Tax Deductions?
Though you can’t currently take miscellaneous itemized deductions for financial advisory fees, there may be other investment-related expenses that you may use to reduce your taxable income.
Investment interest expense
If you itemize, you may be able to deduct the interest paid on money you borrowed to purchase taxable investments—for example, margin loans to buy stock or loans to buy investment property. You wouldn't be allowed to deduct the interest on a loan to buy tax-advantaged investments such as municipal bonds.
The amount that you can deduct is capped at your net taxable investment income for the year. Any leftover interest expense gets carried forward to the next year and can potentially be used to reduce your taxes in the future.
To determine your deductible investment interest expense, you need to know the following:
- Your net investment income, which normally includes ordinary dividends and interest income. It does not include investment income taxed at the lower, long-term capital gains tax rates or municipal bond interest, which is not taxed at all.
- Your total investment interest expenses for loans used to purchase taxable investments.
Qualified dividends
Qualified dividends that receive preferential tax treatment aren't considered investment income for these purposes. However, you can opt to have your qualified dividends treated as ordinary income.
In the right circumstances, electing to treat qualified dividends as ordinary income can increase your investment interest expense deduction, which could allow you to pay 0% tax on the dividends instead of the 15% or 20% tax that qualified dividends normally receive. Here's an example of how it might work.
Capital losses
Losing money is never fun, but there might be a silver lining. Capital losses can be used to offset your capital gains. If your capital losses exceed your capital gains, up to $3,000 of those losses (or $1,500 each for married filing separately) can be used to offset ordinary income and lower your tax bill. Net losses of more than $3,000 can be carried forward to offset gains in future tax years.
To make the most effective use of capital losses, keep track of your investment cost basis. The cost basis is generally equal to an investment's purchase price plus any expenses necessary to acquire that asset, such as commissions and transaction fees.
Managing the Repeal of the Advisory Fee Deduction
You Might Deduct advisory fees directly from retirement accounts
Existing tax law does allow advisory fees to be deducted directly from retirement accounts without penalty or taxes. In this case, the taxpayer benefits from using pre-tax retirement funds to pay the fee. Note that this approach generally does not benefit Roth accounts, where “outside” funds should be used to pay the advisory fee, rather than withdrawing funds from a tax-free Roth. Also, investors cannot deduct funds from a retirement account to pay an advisory fee on the non-retirement portion of the advisory portfolio.
Utilize a trust as owner of the advisory account
The repeal on deducting advisory fees under the new law may not apply to irrevocable (i.e., non-grantor) trusts or estates. In Notice 2018-61, the IRS clarified that, post TCJA, trusts could still deduct certain fees (tax preparation, appraisal, and fiduciary fees, for example). With respect to investment advisory fees, an irrevocable, non-grantor trust may still be able to deduct them depending on the specific facts and circumstances of the situation, and the determination of the tax professional filing the trust tax return. A key variable would be whether or not the fee is related to “incremental” services being performed specifically due to the assets being held in the trust structure (as opposed to individual ownership).The IRS intends to issue additional regulations in this area, which may impact the interpretation of these types of deductions for trusts.
Consult a tax professional
With the complexities of the tax code changes, investors considering these types of strategies should consult with a tax professional.
Where to get help
Tax planning is important no matter what time of year. Be sure to consult your tax professional (CPA, lawyer, or enrolled agent) about your unique situation and especially before you make any decisions that might have significant tax consequences.
Also, going straight to the source is never a bad idea. The IRS has resources that provide examples and detailed explanations of the topics included in this article, including: Publication 550, Publication 529, and the instructions for Form 1040, Schedule A, Schedule D, and Form 4952.