Although we often think of the IRA as simply another account, the tax law generally regards it as a quasi-entity that is separate from the individual who owns it. Both the individual and the IRA have their own separate tax rules that apply; intermingling money is not allowed (due to contribution limits), and even paying each others' costs can get a client into some hot water. Accordingly, clients must be very careful when they use their own "outside" dollars to pay any form of expenses that are associated with the IRA itself. Fortunately, in a recent private letter ruling, the IRS did (re-)affirm that an IRA's wrap fee expenses are an acceptable cost to pay on behalf of an IRA with outside dollars, while not running afoul of the IRA rules and limitations.
Thursday, February 17. 2011
The private letter ruling, 201104061, looked at several different types of "typical" account arrangements where a wrap fee was charged as a percentage of the assets in the IRA. In all cases, the wrap fees covered any transaction costs, broker's fees, and commissions, although in several cases the wrap fees also covered costs associated with ancillary financial planning, investment advice, or even discretionary investment account management.
In the IRS' view, these expenses can be considered "ordinary and necessary" expenses of the IRA, and are more analogous to paying the IRA trustee's fees (which are deductible under Revenue Ruling 84-146) than paying brokerage transaction trading costs (which normally must be capitalized into the cost of the security, rather than claimed as a deductible expense, under Revenue Ruling 86-142). Since the expenses are ordinary and necessary, and are incurred on behalf of the IRA, but are not provided for already via contributions to the plan, under Treasury Regulation 1.404(a)-3(d) they can be treated as IRC Section 212 expenses ("expenses for the production of income") and are not deemed contributions. Without this ruling, the risk would have been that an expense paid on behalf of the IRA with outside dollars might be treated as the equivalent of having made a contribution to the IRA, which the IRA then used to pay its own expenses - which is problematic, given IRA contribution limits. Fortunately, the ruling affirms that such payments on behalf of the IRA (or Roth IRA) with outside dollars are not treated as a deemed contribution, consistent with the IRS' earlier view on this issue reported in Private Letter Ruling 200507021 from several years ago.
Given that the IRS views such payments of Section 212 ordinary and necessary expenses - which is why they are not deemed contributions to the IRA - it would appear that the ruling also re-affirms the view that such payments should be deductible for the taxpayer on his/her own individual tax return, where the costs are paid with outside dollars. Such deductions are not necessarily eligible for the most favorable - as a miscellaneous itemized deduction subject to the 2%-of-AGI floor, and an AMT adjustment as well - but if there is already a desire to pay such expenses with outside dollars to preserve the compounding growth of the IRA, the potential for a deduction only makes the result even more appealing.
On the other hand, it's worth noting that the IRS emphasized in its ruling not the investment advisory nature of the expenses, but the fact that they seemed comparable to administrative and overhead expenses, especially given that the costs allowed for an unlimited number of transactions without incurring additional fees. Thus, although it would appear likely that ongoing investment advisory costs would also be eligible for this same treatment, the focus of the ruling was ultimately on wrap fees that specifically include the benefit of unlimited transactions for the client at no further cost, not "just" investment advisory fees. The risk of a different treatment for investment advisory costs (where transaction costs are separately still passed through to the client) seems low, but nonetheless it is notable that the ruling is not crystal clear on the point (and of course, in any event, private letter rulings cannot be cited as legal precedent).
The bottom line is that the latest private letter ruling appears to continue support for the view that it is acceptable for clients to pay IRA wrap (and investment advisory) fees with outside dollars if they so wish, without having them treated as a deemed contribution to the IRA, and while also being eligible for deductibility as a Section 212 expense. Hopefully, at some point in the future, this treatment will be further clarified by the IRS with a legally binding regulation or revenue ruling, but in the meantime, the footing for this treatment still seems pretty solid.
Either way, though, clients should be cautious never to conduct the transaction the other way around - paying the costs of outside accounts using dollars that are held inside the IRA - or there is a risk of a prohibited transaction under IRC Section 4975 that can disqualify the entire IRA!
So what do you think? Do you have clients pay IRA investment advisory expenses with outside account dollars? Or do you tend to sweep them directly from the IRA?
Tracked: Nov 17, 13:04
There are situations where participants are allowed to self-direct their 401(k) and may be in a position to pay the wrap fee using outside funds and potentially deduct it.
As for the PLR, it's very helpful. Anytime you can get preserve the integrity of the tax deferral and get a tax deduction to boot, what a deal!
By the way, I haven't sat down yet to do the math, but I was starting to think through what the break even point would be if you paid the wrap fee with outside funds without the tax deduction. Theoretically, there would have to be some point in time where the tax deferral makes sense without the deduction.
It seems to me that the "wrap fees" letter is specific in the fee including unlimited trades.
What are your feelings about outside dollars reimbursing the IRA for commissions and fees?
Yes, this PLR would also affirm what you are asking - an IRA that pays its own advisory fee by having the amount swept from the account is not a (taxable) distribution.
Have you seen any white papers or other analyses where the benefits of paying IRA advisory fees via direct IRA withdrawals is compared with the benefits of paying IRA advisory fees with outside (after-tax) dollars, and receiving the miscellaneous itemized deduction?
I know there are a lot of factors and what might be right for one taxpayer may not be right for another. Part of me thinks that paying fees from the IRA allows those particular dollars to be earned without tax, grow without tax, and be spent without tax. But then again, you can reduce your current tax bill by taking an itemized deduction. Any thoughts or references you can point me to? Thanks!
Actually, I did a study of this issue in my newsletter a few years ago, when I wrote about the "Deductibility of Financial Planning Fees" in January of 2009.
The general gist was your outcome - to pay the fees with IRA dollars - especially since in reality, most clients these days are severely limited in claiming any deduction when paying with outside dollars due not only to the 2%-of-AGI threshold on miscellaneous itemized deductions, but especially because those deductions are adjustments for AMT purposes.
Not sure what to say beyond the fact that the IRA custodian must have coded this incorrectly. If the fee was swept directly from the IRA and was attributable to investment management fees due specifically for THAT IRA, the amount is not a taxable distribution. It is a trustee fee of the IRA paid on behalf of itself.
This goes back to Revenue Ruling 84-146, which states that IRA trustee fees are not taxable when paid from the IRA on behalf of itself, and a long list of PLRs (including 201104061 cited in this blog post) that the IRS views ongoing investment management fees ordinary and necessary expenses of the IRA that similar to trustee fees would not give rise to a taxable distribution.
If an amount swept directly from an IRA as an investment management fee attributable to that IRA is included in income on the 1099-R, I can only presume that either the amount was mis-coded by the custodian, or that their systems are out of date. You may need to place a call to the tax department for the custodian to ask them to correct this.
I hope that helps a little?
That does help. BTW, they also include direct charitable transfers in the taxable amount. I think they are either too lazy or haven't given this any thought.
In the case of a qualified charitable distribution, there SHOULD be a 1099-R for the distribution amount, as it did leave the IRA as a distribution.
However, Box 2a of the 1099-R should have a dollar amount of "$0", because none of that distribution should be taxable.
If one spouse's IRA Account paid the management fee for the other spouse's IRA Account - would that be considered a prohibited transaction under IRC Section 4975 that can disqualify the entire IRA?
In other words, does "outside account" mean any other account that is not the IRA Account in question?
Yes, using an IRA to pay your spouse's IRA account fee would definitely be a prohibited transaction. You're using your IRA to benefit a related person (your spouse); definitely not appropriate under the IRC Section 4975 rules.
At the least, each spouse's IRAs should support their own IRA fees with respect to that spouse.