Among the many different changes made to the tax code in the recent tax overhaul is one that many people would be forgiven for missing: the closure of the investment expense deduction. You could be forgiven for not understanding the ins and outs of how investment income is taxed, let alone having a knowledge of the tremendous number of potential tax deductions out there. However, for a select few, next April will see those people losing access to the ability to deduct the fees and commissions charged by their brokers and investment advisors.
So, here’s a closer look at the investment expense deduction and how it might (or more likely won’t) affect your traditional IRA.
What Was the Investment Expense Deduction?
Investment expenses — which can include fees, commissions and interest paid on margin borrowing — were among those itemized deductions you could make on your Schedule A. So, whatever money you paid to a financial advisor or broker could potentially come back to you at the end of the year, not unlike the fees you would pay an accountant.
If you’re hearing about this for the first time, that’s probably because this itemized deduction’s use was typically somewhat limited.
The investment expense deduction was subject to the 2 percent limit, meaning you could only claim it if your investment expenses exceeded 2 percent of your gross income. For someone making the median household income in the U.S. of $55,322 a year, they would need at least $1,106.44 in fees and commissions to qualify — and they could only deduct those expenses that exceed said $1,106.44. Also, that’s in addition to opting to itemize instead of simply accepting the standard deduction.
And finally, the deduction was only applicable to investments that produced taxable income. So unless you made a withdrawal, you couldn’t use it.
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How Will This Affect Me?
The good news is that the vast majority of Americans probably didn’t qualify for this deduction so this change probably won’t impact your taxes. That’s because for most retirement accounts, $1,100-plus in fees would be pretty substantial — if not outrageous — especially when you consider things like mutual fund expense ratios and per-trade commissions fees don’t qualify. Expense ratios for ETFs and mutual funds are taken out before profits are calculated, and fees for the sale or acquisition of investments are specifically excluded.
And of course, all of this is a moot point unless you’re collecting taxable income from your investments — like a qualified dividend or a distribution. If you aren’t receiving any money from your IRA or 401k yet — maybe because you’re reinvesting dividends and not making withdrawals or distributions — you didn’t qualify.
This scenario is different for a select set of people, though. The wealthy, for instance, would be more likely to employ a wealth manager or financial advisor, much less likely to take a standard deduction and the famed “2 and 20 fees” paid to hedge funds came after taxes and did qualify.
If you’re a retiree, the odds are also much better that you made use of the investment expense deduction. Your taxable annual income is more likely to be relatively low and derived entirely from investment income, and your nest egg is more likely to be significantly larger than someone in their 30s or 40s — likely resulting in higher costs.
Regardless, if you haven’t heard of the investment expense deduction before, the odds are pretty good that it’s because you didn’t qualify. However, if you do have a large nest egg or employ a financial advisor to manage your money, it might be time to consult with your accountant to learn if you can expect an increase in your tax burden for the 2018 tax year.
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