Are Mutual Fund Expense Ratios Tax-Deductible?
Save your statements if you're paying an investment advisor directly.
Question: I know that some investment-related costs are tax-deductible. Do mutual fund expense ratios count?
Answer: IRS Publication 529 provides a sweeping overview of the various costs that are--and are not--allowable miscellaneous deductible expenses under IRS rules. Such expenses are deductible if they, in aggregate, exceed 2% of the taxpayer's adjusted gross income, and if they do, only the amount that exceeds 2% of AGI is deductible. So, for example, if you report $75,000 a year in adjusted gross income and have $4,000 in such miscellaneous expenses, you can deduct $2,500 of that amount. (The first 2% of your AGI, or $1,500, isn't deductible.)
For example, Ponzi-scheme losses are deductible as miscellaneous deductible expenses (phew!), whereas wristwatches (?) and meals with coworkers are not. The publication also states that investment costs can be included as part of your miscellaneous itemized deductions, provided they produce taxable income that can be included in your gross income.
At first blush, mutual fund expense ratios might seem like they could fall under that umbrella, because a central goal of many fund investors is to garner income. And there's no doubt that being able to deduct those costs could really lighten your tax load. For example, if you were paying 1% a year to a fund company to manage your $500,000 portfolio and your AGI was $100,000, you'd be able to deduct $3,000 in expenses right there. ($5,000 for your fund expense ratios, minus $2,000--the 2% "floor" of AGI that is not tax-deductible).
Unfortunately, however, a closer read of the facts indicates that those expense ratios aren't deductible after all. That's because the expense ratio you pay for your fund reduces your income payout accordingly, so you're not taxed on that amount as income in the first place. To use a simple example, say you invested in a bond mutual fund whose pre-expense yield was 4%. But factoring in the fund's 1% expense ratio, your take-home yield is just 3%, and you would owe taxes on just the 3% of income rather than the whole 4%. For that reason, your 1% expense ratio wouldn't be a deductible expense. (See page 10 of IRS Publication 529 for more details.)
The same general logic holds true for another major expense for individual investors--brokerage commissions paid to buy and sell shares of stocks, funds, and ETFs. The trading commissions you pay are deducted from your purchase and sale prices, which in turn affects your cost basis and your return. For example, say you pay $2,700 for 100 shares of Microsoft (MSFT), along with a $10 brokerage commission to execute the trade. Your cost basis is $2,710. When the stock climbs to $40, you decide to unload your shares, paying another $10 commission, reducing your sales proceeds to $3,990. You'd thus owe taxes on your $1,280 gain--your sales price of $3,990 minus your cost basis of $2,710. Because your purchase and sale prices have been adjusted for your commissions, you've already effectively skirted taxes on those commissions, and they wouldn't be deductible as miscellaneous expenses.
So if brokerage commissions and mutual fund expense ratios are off the table, what is deductible as an investment expense, then? If you pay for financial advice--either as a percentage of your assets on an ongoing basis or by writing a check directly to your advisor--those fees can be counted as part of your miscellaneous itemized deductions, whether you've made money with your advisor in a given year or not. If your broker is fee-based--meaning he uses some commission-based products but also charges you a fee--you can deduct the portion of your costs that isn't a commission. You can also deduct subscriptions for investment newsletters and Internet subscriptions (including Morningstar.com Premium Membership), but fees to attend investment conferences for your own investment edification are not considered deductible expenses.
If you use a fee-only advisor and have a sizable portfolio, those investment-advice fees can add up, so it pays to keep track of them. (Many advisors provide their clients with a summary of the previous year's taxes at the start of each year; if yours doesn't, be sure to ask for an accurate accounting.) Combined with other miscellaneous itemized deductions, those investment-advice expenses can provide meaningful tax savings.
However, bear in mind one last wrinkle: If you're subject to the alternative minimum tax, several deductions go on the chopping block. That means AMT filers can't deduct state and local taxes, property taxes, or miscellaneous itemized expenses--including expenses for investment advice--even though those deductions are available to taxpayers who aren't subject to the AMT.
Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.