Many readers of this blog contact me directly with questions and comments. While often the responses are very specific to a particular circumstance, occasionally the subject matter is general enough that it might be of interest to others as well. Accordingly, I will occasionally post a new "MailBag" article, presenting the question or comment (on a strictly anonymous basis!) and my response, in the hopes that the discussion may be useful food for thought.
In this week's MailBag, we look at a question about whether investment advisory fees can be paid directly from an annuity account, and the prospective tax issues involved in paying investment management fees associated with annuities.
Question/Comment: Given that investment management fees can be paid directly from an IRA on a pre-tax basis, I'm wondering if the same rule applies to annuities as well? Can my client pay my advisory fee for managing an annuity directly from the annuity's cash value on a similar pre-tax basis, and if so how does all this get reported on the Form 1099-R?
Unfortunately, the reality is that in today's environment, the tax treatment for this approach is not so favorable.
As I've written on this blog in the past, paying investment management fees directly from an IRA on a pre-tax basis, without having the amounts treated as a taxable distribution, is legitimate. Treasury Regulation 1.404(a)-3(d) permits retirement accounts to pay their own expenses, including so-called "Section 212 expenses" (fees associated with managing property held for income), and PLR 8951010 ruled that in a scenario where the IRA is directly responsible for the investment management fee, it can be treated as a Section 212 expense (and therefore excluded from income). With the combination of these two rules, investment management fees can be paid directly from an IRA to the investment manager on a pre-tax basis, without triggering a Form 1099-R.
In the case of annuities, however, the situation is less straightforward. First of all, there is no comparable ruling to Treasury Regulation 1.404(a)-3(d) and PLR 8951010 in the case of annuities. Second, and perhaps even more problematic, is that the only way the fees were permitted to be paid in the case of IRAs without triggering income tax consequences is that the fee was the sole responsibility of the IRA, and a payment owed and made directly to (i.e., swept directly by) the investment manager from the IRA. In the case of a true "investment manager" (i.e., an RIA) this cannot be done, though; to be paid directly, the advisor would have to be FINRA-registered and insurance-appointed with the annuity company and paid a (trail) commission directly from the annuity company, or the investment advisor would have to be contracted as a subadvisor to the particular fund(s) that the client uses within the annuity (i.e., paid like any other mutual fund manager who's responsible for some of the investments inside the annuity). The latter is generally not feasible for any individual advisor, and the former is typically not an option for investment advisors who are trying to charge such fees in the first place.
So what would happen if the investment advisor tried to get paid directly from the annuity anyway? The annuity company would issue a Form 1099-R to classify the payment as a taxable distribution on behalf of the annuity owner. The standard gains-first ordinary-income treatment would apply to the distribution, along with a potential 10% early withdrawal penalties. The subsequent payment of those funds to the investment advisor would then likely be deducted as a miscellaneous itemized deduction subject to the 2%-of-AGI floor (as it is a payment for managing investment assets), and the miscellaneous deduction would hopefully offset the amount of income just reported on the Form 1099-R. Unfortunately, in reality the amounts probably will not offset, due both to the 2%-of-AGI floor on miscellaneous itemized deductions in the first place, and the fact that such deduction are an adjustment for AMT purposes.
Of course, the reality is that if the client simply wanted to try to get a tax deduction for paying investment management fees associated with an annuity, this can be done without the annuity distribution in the first place. The client can simply write a check for investment management fees - including those attributable to an annuity - and claim the same miscellaneous itemized deduction as a Section 212 expense, the same as can be done by paying the investment management fee for an IRA using outside dollars. In fact, given that reality, it's hard to see why there would be any reason to ever try to pay the annuity's fees with money from inside the annuity, when they can be paid with money from outside annuity for the same tax deduction but without the unfavorable Form 1099-R, taxable distribution, and potential early withdrawal penalty. In other words, from the tax perspective, paying such fees directly from the annuity is exactly the same as saying “Take the withdrawal from your annuity, deposit it in your checking account, then write a check to your advisor for investment advice, and claim the 2%-of-AGI miscellaneous itemized deduction.” If you're going to have the distribution treated as a taxable distribution followed by a deductible payment from your checking out, just use other money from the checking account and skip the unfavorable taxable distribution!
Notably, this result produces an odd distinction between investment advisors and FINRA-registered brokers: investment advisors must have their fees paid with outside dollars to be deductible (and even then the favorable tax treatment is limited), while similar fees paid to a broker in the form of a trail commission that really are subtracted directly from the cash value of the annuity by the annuity company receive more favorable treatment (since the fees directly reduce the account value, it's the equivalent of getting to pay the fee 100% pre-tax, assuming there are any gains in the annuity in the first place). While that may seem unusual, unfortunately the reality is that's simply how the rules are written at this point!
I hope that helps a little? If you'd like some further objective information and education on the technical tax laws surrounding annuities, you might also wish to check out my book "The Advisor's Guide To Annuities" as well!
If you're interested in having your question evaluated as a potential MailBag article on Nerd's Eye View in the future, please email MailBag@kitces.com.