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Roth IRA Investment Fees: Pay Personally or Deduct From the IRA Account?

Estate, Trust & Wealth Preservation Alert John T. Bannen

Roth IRAs have a unique advantage under the Internal Revenue Code. They can be invested in what would ordinarily be taxable interest, dividends, or taxable capital gains, and pay no tax when the funds are distributed from the Roth account. The Roth IRA is that coveted engine that converts taxable income into tax-free income. "Read my lips: No tax. Not now, not ever."

Of course, some restrictions apply. For example, the assets must be held in a Roth IRA account that has been in existence for five taxable years. In addition, Roth IRA accounts are directly available only to persons below certain income levels or indirectly by making non-deductible contributions to traditional IRAs and doing a Roth conversion, regardless of income; this is commonly referred to as the Backdoor Roth IRA.

So, putting as much money into your Roth IRA and keeping it there is the name of the game.

Depending on how you invest your Roth IRA account, you will probably be charged some administrative expenses. There may be a nominal annual fee (say, $75), but if you are paying for investment advice with an asset-based fee, you may be paying a healthy amount. Roth IRAs hold funds which will earn tax free income for what may be a long, inter-generational period. Wouldn’t it be nice if you could pay those fees from assets outside the IRA account and leave more dollars to grow those magically tax-free dollars in your Roth IRA account?

Enter Rev. Rul. 84-146 to the Rescue.

From time to time, the IRS publishes new rules in releases called “Revenue Rulings.” One of these rulings allows you to pay trustee fees, annual investment management fees (also called “wrap fees”), but not brokerage commissions, from non-IRA funds without them being considered an additional contribution to the IRA account.Because Roth IRA assets are not touched, the ability of the account to earn tax-free income is not impaired. More money in the account means more tax-free income can be earned.

So far, so good. You may wonder if these “investment advice fees” that you have just paid would be deductible as an itemized deduction as expenses incurred in the production of income, albeit subject to a 2% adjusted gross income haircut. Sadly, there is no double-dip here. Internal Revenue Code denies a deduction for expenses incurred for the production of income which is exempt from tax. If you don’t pay tax on the income earned, you can’t deduct the expenses incurred to earn it.

Even though the expenses paid are non-deductible, maintaining assets inside the Roth IRA, thereby producing tax-exempt income, is still a winning strategy. To facilitate this result, have your IRA investment advisor bill you personally for the investment advice and pay for those services from personal, non‑Roth IRA funds. If for some reason this is impossible, reimburse your Roth IRA account for the expenses, but be sure your IRA sponsor uses their internal code that allows your account to be credited without the money being considered a contribution. Otherwise, if you have already made the maximum contribution (or are not eligible to make a contribution at all), you would have contributed too much and would be liable for a 6% excess contribution penalty.

What About Paying Investment Fees Related to Traditional (non-Roth) IRA Accounts?

Paying investment fees for traditional, non‑Roth IRA accounts which will produce taxable income when distributed is more complex. First of all, such fees are deductible as an itemized deduction but only if, when combined with other miscellaneous itemized deductions, they exceed 2% of your Adjusted Gross Income. This is an insurmountable obstacle for many. Also, if you are subject to the Alternative Minimum Tax, the AMT will effectively negate the benefit of the deduction.

Because distributions from Roth IRAs will never be taxable when received, the best strategy for all Roth IRA owners (and their beneficiaries after the owner’s death) is to pay all expenses from non‑Roth IRA assets and maintain maximum balances in the Roth IRA.

For more information, contact John T. Bannen at (414) 277-5859/[email protected], or your Quarles & Brady attorney.