Q. I’m going to work with a financial planner and I have two ways I can pay the 1% management fee. Either I can pay cash (then it’s deductible) or it can be taken from my retirement accounts (then it’s not, but it’s not a cash flow issue). What are the pros and cons?
A. There are definitely pros and cons in terms of what accounts you use to pay your financial planner, but there are other things to consider before making that decision.
There are many types of payment models for financial services professionals, said Jeff Rossi, a certified financial planner with Peak Wealth Advisors in Holmdel.
He said some get paid commissions and fees based on products they sell to you, while others charge a percentage of the assets they manage, while others may even charge hourly or on a retainer basis for investment management and/or financial planning services.
It depends on the financial services professional, the organization they work for, and of course, the preferences of the client, Rossi said.
He said one of the most common ways for a fee-only or fee-based planner to assess fees is based on assets under management (AUM).
“Most investors and financial professionals feel that this model aligns the motivations of both parties because it’s win-win if the value of the portfolio increases,” Rossi said. “That said, it’s not without its cons.”
Rossi said dissenters will point to situations when a financial professional recommends an investor transfer assets from a 401k into an IRA so that the financial professional could include the assets in his or her AUM.
No compensation model completely eliminates conflicts or issues, Rossi said.
“The best way to pay your financial professional is via a model that aligns with your specific situation and needs,” Rossi said. “It pays to ask a lot of questions about fee structures before signing on the dotted line.”
If you’re not sure what to ask, the National Association of Personal Financial Advisors (NAPFA) has a list of tips and questions for consumers to ask when interviewing financial planners.
When paying via an AUM model, some things are not as clean cut as they may seem.
If you pay the fee out of a taxable account, Rossi said, it’s generally deductible to the extent the investment-related expenses — along with your other miscellaneous itemized deductions — exceed 2% of your adjusted gross income (AGI).
“The caveat is that the portion of the expense that is deductible needs to be tied to investment management and not financial planning,” he said. “Sometimes it’s not clear where financial planning services end and investment management work begins, which is why a 1% AUM ‘bundled’ fee can cause some questions if you were to get audited after taking the deduction.”
Some people prefer to pay the fees via a retirement account because taking it out of the retirement account (assuming it’s pre-tax) can reduce Required Minimum Distributions (RMDs) in the future, Rossi said.
He said others prefer to pay fees from a pre-tax account such as an IRA because that money has not been taxed and when it is paid to the financial adviser, it’s one of the few times earned income is never taxed.
“The major caveat with paying fees from an IRA is that the fees should be for investment management services on the IRA,” Rossi said. “When an IRA’s assets are used for other non-IRA expenses, it is deemed to be a distribution from the account, and in extreme situations could cause the IRA to lose its tax-qualified status.”
Most financial planners can set up AUM billing per account, so a blended approach may work best if you want to realize some of the benefits of paying from an IRA, Rossi said.
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- The Credit.com Credit Reports Learning Center
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- How Credit Impacts Your Day-to-Day Life