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How to Pay IRA Expenses

Payment of the management fees for an IRA presents planning opportunities--and pitfalls.

Natalie Choate, 10/11/2013

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 present some tricky hurdles and pitfalls:

Natalie Choate practices law in Boston with Nutter McClennen & Fish LLP, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is a leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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