taxes
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A few questions have come up from clients regarding the tax deductibility of investment management fees paid for ongoing advisory services such as Pariveda's 401(k) Manager & Wealth Manager services. Here’s a quick overview.
Investment management fees are considered a “below-the-line” miscellaneous expense for the taxpayer and are therefore deductible to the extent that they, combined with all other miscellaneous expenses, exceed 2% of the taxpayer’s adjusted gross income (AGI). The taxpayer is eligible for the deduction regardless of whether the account(s) in question are taxable, tax-deferred, or a combination.
However, in cases where the taxpayer falls under the Alternative Minimum Tax all “below-the-line”, including those for investment management fees, are disallowed.
Until a few years ago, there was confusion surrounding whether advisory fees paid for tax-deferred accounts such as IRAs and 401(k)’s had to paid from funds within the account, or whether these fees could be paid from outside funds, and if so, if these fees would be considered tax deductible. All this was cleared up in a 2005 private-letter ruling:
Interestingly, while advisory fees paid for tax-deferred accounts are deductible, brokerage commissions are not.
It’s tax season again, and that means questions, questions,
questions. Over the course of the next
few months we’ll be putting forth what we believe to be useful tidbits for
investors with taxable accounts. This is
the first.
Say you’re an investor holding mutual fund shares in a taxable brokerage account. You’ve elected to “re-invest” all distributions in the fund, meaning that dividends, as well as short and long-term capital gains are all paid out to you and then re-invested into additional shares of the fund. Your initial investment was $2,500 and over the past 3 years capital appreciation and re-invested distributions have allowed you to build up a sizable stake in the “XYZ Fund”. Further let’s assume that in each of the past 3 years the fund paid out $200 in distributions that were re-invested. On the last day of 2006, your stake is worth $5,000 and you sell your entire position. What’s the gain on which you’re taxed?
If you answered $2,500 (the $5,000 sales proceeds less the $2,500 initial investment), you’d be wrong and, more importantly, end up paying too much in taxes.
The correct tax basis is the summation of all money used to purchase shares – both the initial investment and all re-invested distributions. In this case this amounts to $3,100. So, when you go to sell the XYZ Fund, your realized gain would be $1,900 (the $5,000 sales proceeds less the $3,100 adjusted cost basis of all your shares).
Further, while the distributions are re-invested in additional XYZ shares each year and the re-invested amount added to the share basis, the distributions themselves are taxable in the year in which they’re paid out, regardless of the fact they’re re-invested. For example if the $200 in the first year were comprised of $100 long-term gains and $100 in short-term gains, you’d recognize these payouts on your year 1 tax returns.
Finally, if a re-invested distribution is held less than a full year, the shares purchased with this distribution are taxable as short-term gains (or losses) in the year the position was liquidated. Using our example, assuming the fund paid out its last distribution on December 1, 2006 and the entire position was then liquidated on December 31, 2006 the shares purchased with the last distribution are short-term gains or losses. The remainder would be taxed as long-term gains/losses.
Most accounting software such as Intuit Quicken and Microsoft Money automatically account for these distributions correctly. However, if you’re not using personal finance software, the steps noted above should help you avoid paying too much to Uncle Sam.
