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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:

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.

What do practitioners say about Natalie Choate's book Life and Death Planning for Retirement Benefits? "I sleep with your book under my pillow." "We regard your book as the ultimate authority." "I wish more people wrote books the way you do." "Your book has been a tremendously valuable resource to our firm." "I have found this book extremely helpful." "We have read and used it in many cases already." "It's paid for itself already." "I ordered these for our company last week, and everyone loves it!" "GREAT BOOK!" To find out why your colleagues (and competitors) are raving about Life and Death Planning for Retirement Benefits, visit http://www.ataxplan.com.

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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