Managing finances can be a challenging affair. Even if you feel confident enough when making financial decisions, you cannot be certain that the decisions you make can help you reach your financial goals. What you can do is hire a financial advisor who can help you design a foolproof financial plan, make sound financial decisions, and can have a meaningful impact on your investment returns and long-term financial goals. With a competent financial advisor, you will be able to handle several crucial aspects of financial planning such as budgeting, saving, debt management, investing, retirement planning, estate management, etc. According to a study, expert financial advice can boost your investment returns by as much as 3 percent a year. A financial advisor can help you save time, reduce money-related stress and offer timely financial advice.
In spite of these significant benefits, many people remain of two minds when it comes to hiring a financial advisor. Typically, a financial advisor's fee consists of 1 percent of your assets under management (AUM) each year. While this may seem like a significant amount, the cost is inconsequential when weighed against the improvement in returns. In addition, you benefit from having peace of mind knowing that your finances are in good hands. As per a recent study, 66 percent of the respondents with a financial advisor stated that they were financially secure. Additionally, 85 percent of the survey participants specified that due to having received professional financial advice, they were on the right track with their finances.
Apart from the aforesaid monetary and non-monetary benefits, you can also avail of tax benefits if you engage the services of a financial advisor. Up till 2017, investment and financial planning services were listed as miscellaneous itemized deductions, where you could avail partial or total exemption on your federal income tax returns. This was however changed in 2018, with the passing of the Tax Cuts and Jobs Act, where changes were made to what items could and could not be treated as tax-deductible. Read on to learn more about tax-deductible advisory fees and how you can benefit from it.
Are investment advisory fees tax-deductible?
Before the Tax Cuts and Jobs Act, 2017 was passed, you could derive a tax benefit by deducting the fees paid to a financial advisor for ‘investment advice’ by adding them under the miscellaneous expenses section on Schedule A of your income tax return for the year. Under this head, you could show the following expenses as deductions:
- Financial advisor fees
- Custodial fees for an IRA (Individual Retirement Account)
- Legal and tax-related counsel charges
- Accounting costs
- Trustee fees
To qualify for this advisory fee tax-deductible, your miscellaneous itemized deductions should have been higher than 2 percent of your annual adjusted gross income (AGI). For example, say your AGI was $500,000 in 2016, then miscellaneous expenses (including financial advisor fees and investment-related expenses) over 2% of your AGI or $10,000 were eligible for deduction from AGI. So, if you paid $15,000 as fees for financial advisory services in 2016, then you could deduct $5,000 from your AGI. Alternatively, if your financial advisor fee or related investment expenses were under 2% of your AGI or less than $10,000, then you would not qualify for the deduction.
To calculate your AGI, you must deduct any personal exemptions and itemized deductions from your total annual income (including wages, dividends, salaries, bonuses, and capital gains). The IRS uses the AGI to calculate an individual’s yearly tax liability.
But the category of miscellaneous itemized deductions was removed after the Tax Cuts and Jobs Act was enforced in 2018. This means that you could no longer avail of the aforementioned tax-deductible from the tax year 2018. The aforesaid change in the tax code will remain effective till 2025 unless the government renews it.
Does the new tax code affect any change in the investment advisory fees tax deductible status?
Yes, it does. Now the compensation you pay to your financial advisor comes under the standard deductibility rules unlike earlier when you could qualify for a tax deduction for advisory fees paid to a financial professional. At present, you can avail of tax deductions only if you are incurring an expense for earning assessable income. Here, assessable income refers to the income subject to federal income tax laws.
You can still claim a deduction for the financial advisor fee, provided that the financial advice directly leads to a purchase of an investment option that generates taxable income. On the other hand, if you pay your financial advisor for advice that does not help generate any taxable income, then the investment advisory fee is not tax-deductible. For example, if you wish to engage the services of a financial advisor to help you with loan processing for your private home, then, in that case, the fees you pay the advisor for their counsel will not be tax deductible because you will not be earning any money from the property you are buying. Alternatively, if you were to hire a financial professional for help to get a loan for a commercial property purchase, then in that scenario, you can claim a tax deduction for the fees paid to the expert for their advisory services.
Can I no longer benefit from tax deductions after the Tax Cuts and Jobs Act?
Even though the passing of the Tax Cuts and Jobs Act limits your ability to claim tax deductions, you have not lost the complete benefit. In several cases, the removal of the tax deductions has not resulted in any change in the income or the tax benefits. Primarily only those investors have been affected by the elimination of the miscellaneous tax deductions who paid fees for investment advisory services as a percentage of their assets invested in non-qualified investment accounts. Herein, a non-qualifying investment account (a custodial account, Transfer-on-Death (TOD) account, individual or joint account, etc.) cannot avail of any tax benefits, however, non-qualifying investments are taxed annually.
Which tax deductions can you claim as a part of the investment advisory fees as an investor?
At present, you can claim the following deductions as a part of the investment advisory fees tax deductible:
- Taxable income: Barring some limitations, you can deduct the fees paid to a financial advisor for investment counseling and advice. The IRS allows you to claim a deduction for expenses if the investments you invest in generate a taxable income. On the other hand, if the investments do not generate taxable returns, you cannot avail deductions for the fees paid to the advisor. For instance, if your advisor buys tax-exempt municipal bonds, you will not be able to claim any tax deductions because the income from these bonds cannot be taxed. However, when you sell these bonds at a future date for a profit, you would be generating taxable income in the form of capital gains. In this case, you would need to calculate the percentage of your financial advisor fees based on the taxable income generated by the particular investment.
- Travel expenses: If you hire a financial advisor who lives in a different city or state than you and you incur travel expenses when going in for a consultation, then you can claim a deduction for the travel expenses incurred by you for seeking financial advice. Herein, travel expenses would include transportation and lodging costs like airline tickets, hotel bills, meals, etc. However, if you are traveling to attend a convention, investment/financial planning seminar, stockholder’s meetings, etc., then your expenses would not qualify for a deduction.
- Interest expenses: You can get a tax deduction on the interest paid on the money borrowed to buy taxable investments under the new tax regime if you itemize on Schedule A. You can do the same for the interest paid on margin loans as well. Do note that the maximum deduction that you can get is the amount of net taxable investment income for the particular year.
- Investment portfolio costs: When you set up an investment portfolio or a financial plan, the initial expense that you incur is classed as a capital expense and is not deductible. However, if you pay fees at regular intervals to your financial planner to maintain your financial plan or portfolio, that expense is eligible for a tax deduction, provided the expenditure is related to earning taxable income. If you consult with your advisor on the management of private loans or insurance premiums, then only a specific part of the expenditure incurred is tax-deductible. In addition, any fees paid by you for tax advice on investments would also be deemed as tax-exempt.
- Miscellaneous expenses: Even if you spend a considerable sum of money on financial advisory fees, you may not be able to write off the full amount. However, you can claim deduction on a specific part of the fees. You can do so by itemizing your deductions though do keep in mind that this may not be the wisest thing to do since the standard deductions have nearly doubled over the last few years. You can include your investment advisory fees in miscellaneous expenses, subject to the 2% rule wherein only those miscellaneous expenses that exceed 2% of your AIG can be deducted. In certain scenarios wherein your deductible expenses are above the standard deduction, itemizing deductions can be a good strategy. The deductible expenses here include student loan interest, traditional IRA contributions, etc. You can choose between itemizing your expenses or taking the standard deduction route by making some straightforward calculations. Assess how much you will pay in taxes when you take the standard deduction against itemized deductions.
What are the other ways in which I can reduce my taxable income?
The primary motive of using the investment advisory fees tax deductible is to reduce your taxable income and tax liability. You can reduce your taxable income through other methods as well, such as:
- Investing in qualified accounts: By investing in qualified accounts such as an IRA, 401(k), etc., you can take advantage of tax-deductible contributions since the contributions made to these accounts are tax-exempt, thereby, they help lower your annual tax liability. However, there is a limit on how much you can contribute to such an account. The maximum deduction depends on your income, tax filing status, and other factors. For example, for the year 2021, you can contribute a maximum of $6,000 to an IRA, which can be bumped up to $7,000, if you are above 50 years of age. The amount you contribute can be used to reduce your taxable income by that amount consequently, helping you lower your tax liability. You would be wise to maximize your contributions to such qualified accounts and reduce your taxes instead of choosing to go for itemized deductions.
- Contributions towards an HSA: You can make tax-deductible contributions every year to an HSA or a Health Savings Account as per the contribution limits set by the IRS. For the year 2021, you can make a contribution of $3,600 for a self-only HSA whereas, for a family HSA, the upper limit is set at $7,200. These contributions can be boosted by an additional $1,000 per year if you are above 55 years of age
- Investing in tax-efficient securities: You can lower your tax bill by making tax-efficient investments such as ETFs (Exchange Traded Funds) which are a portfolio of securities, such as stocks and bonds. The twin benefits of ease of buying and selling ETFs and low transaction costs make ETFs a quality tax-efficient investment.
- Portfolio diversification: By diversifying your portfolio, you can protect yourself against market fluctuations by spreading risk in different kinds of investments such as stocks, bonds, real estate, gold, cryptocurrency, etc. You can lower your tax liability through depreciation deductions that can be availed on real estate properties and rental profits. Here, depreciation refers to a decrease in property value due to wear and tear, decay, age, etc. Under the U.S. tax code, private real estate investors can benefit from a depreciation deduction that enables them to recover some capital to reinvest it in real estate over time. You can avail of these deductions even if the cash flow from the property is positive provided you meet certain eligibility criteria for claiming depreciation deductions.
- Investing in assets for the long term: By holding on to assets for a longer duration, you can potentially increase your returns and lower your tax bill in the future. In addition, if you hold your investments for a longer period of time, you can benefit from the long-term capital gain tax which is lesser than the short-term capital gain tax. Short-term capital gain tax is levied on the sale of securities held for less than one year and the gains are taxed as ordinary income. This consequently increases the amount of taxes that you need to pay by pushing you into the higher tax bracket. In some cases, the tax rate could be as high as 35 percent depending upon your AIG. On the other hand, you only need to pay a 20 percent tax rate on securities held for more than one year. Moreover, if you fall in a lower tax bracket, you can qualify for a 0% long-term capital gains tax rate.
- Implement tax-loss harvesting strategies: By deploying tax-loss harvesting strategies, you can lower annual tax liability by offsetting your capital gains with specific investment losses. In this strategy, you sell any investments (including stocks, bonds, mutual funds, ETFs, etc.) operating at a loss to counterbalance any capital gains made by selling other investments. By using a tax-loss harvesting strategy, you can limit how much profit you make through short-term capital gains to focus more on exploiting low long-term capital gains tax rates. An important thing to keep in mind when using tax-loss harvesting strategies is that you do not fall astray of the wash sale rule mandated by the IRS. According to the wash sale rule, you cannot repurchase an investment sold at a loss with the same or a similar security 30 days before or after selling the investment.
In 2021, the advisory fees tax deductible IRS status is non-deductible after the enforcement of the Tax Cuts and Jobs Act. However, the rules may change in 2026, with the expiry of the aforesaid act, paving way for favorable tax benefits for financial advisory services. Meanwhile, you can benefit from several other tax-saving opportunities available to you. Consult with a professional financial advisor to find ways to increase your investment returns and reduce your tax liabilities. Use the free advisor match tool and get connected with 1-3 vetted financial advisors suitable for your financial needs.