Tax Planning

Experts highlight the tax issues every financial adviser should know

Fees v. commissions: Different tax advantages

Advisers need to create a pricing model that best reflects the type of business they run and the services they provide

Aug 28, 2015 @ 11:50 am

By Tim Steffen

In a year like 2015, when equity indexes such as the S&P 500 and Russell 2000 have provided the slimmest of returns, advisers and their clients are especially aware of any kind of drag on investment performance. Naturally, investors eventually will look at the expenses paid to his/her adviser. Good advisers can justify their expense based on the added value they provide, but being able to explain the tax advantages of those expenses may help even the most fee-sensitive client.

A basic tenet of tax law is that expenses paid to generate taxable income are tax-deductible. However, the method of deducting those expenses and the tax benefit of that deduction vary considerably based on the type of expense paid.

Commissions add to the cost of each transaction

The fees paid by investors generally fall into two categories: commissions or fees. Commissions have long been the standard for how advisers are paid, and that pricing model is still very prevalent today. Every time an investor buys something in his/her account, he/she pays an additional cost — typically a charge based on the number of shares purchased. When that investment is later sold, a portion of the sales proceeds are paid to the adviser, again typically a per-share fee.

Commissions paid to purchase an investment are added to the cost basis of the investment, so purchasing 100 shares of stock for $10 each plus a $0.10 commission per share would result in a total cost of $1,010. If those shares are later sold for $15 each, and another $0.10 per share commission is paid, the net sales proceeds would be $1,490.

For tax purposes, the gain on that investment is the difference between the total purchase price and net sales proceeds, or $480, even though the stock itself increased in value by $500. In this case, the commissions paid reduced the taxable gain and therefore the capital gains tax paid by the investor.

Asset-based fees are trickier to deduct

The trend for many years has been for advisers to charge their clients a fee based on a percentage of the value of the account. Because the fee typically has no correlation to the number of transactions, it can't be assigned to a specific investment and treated as part of the purchase price.

Instead, these expenses fall into a category known as miscellaneous itemized deductions, which also includes items such as unreimbursed business expenses, tax preparation fees and union dues. All these expenses are combined together, and in total must exceed 2% of adjusted gross income before there is any tax benefit. For example, assume a taxpayer has AGI of $200,000 and total miscellaneous deductions of $5,000. Their 2% floor is $4,000 and only the expense amount over that floor is deductible — $1,000 in this case. The other $4,000 in expenses are lost and cannot be carried over into a future year.

Which is better?

Saying which pricing model is better for tax purposes is difficult to discern. Unlike commissions, which provide a definite tax benefit in the form of a reduced capital gain, the tax benefit of investment fees is much more uncertain. High-income taxpayers may find it difficult to exceed the 2% of AGI floor, and therefore do not receive any tax benefit for the fees they pay. Even those whose total miscellaneous deductions exceed the AGI floor may run into another hurdle — alternative minimum tax. The AMT rules do not allow a deduction for these expenses, so an investor that is close to or in the AMT will not receive a tax benefit at all.

On the other hand, investment fees are deductible in the year they're paid, whereas commissions only provide a tax benefit when the investment is eventually sold — potentially many years after the purchase commission is paid. Also, any miscellaneous deductions over the AGI floor are first used to offset ordinary income, not capital gains. This means the tax benefit could be as large as 39.6%, the top tax rate on ordinary income, rather than the 23.8% top rate on long-term gains.

Ultimately, advisers need to create a pricing model that best reflects the type of business they run and the services they provide. The tax treatment of the fees they charge should be just one of the factors they consider.

Tim Steffen is director of financial planning for Robert W. Baird & Co. Follow him on Twitter .


What do you think?

View comments

Recommended for you

Upcoming Event

Apr 30


Retirement Income Summit

Join Mopedia at the 12th annual Retirement Income Summit - the industry's premier retirement planning conference.Much has changed - and much remains to be learned. Attend and discuss how the future is full of opportunity for ... Learn more

Tom Florence, CEO of 361 Capital, discusses growing investor complacency and why he thinks overconfidence might be creeping into adviser and investor decision making.

Video Spotlight

Sponsored by Prudential

Recommended Video


Latest news & opinion

Merrill likely next big firm to dump broker recruiting protocol

Recruiters say Merrill Lynch, like Morgan Stanley and UBS, has already moved away from the traditional recruiting model and is more apt to leave the protocol than Wells Fargo.

Vanguard rolls out actively managed factor ETFs

The six ETFs and one mutual fund, which will focus on volatility, value, momentum, liquidity and quality, mark a departure from the money manager's storied promotion of passive index funds.

UBS broker-protocol exit shows independent channel is bleeding wirehouses of advisers

Smaller shops have benefited from the broker protocol at the expense of larger firms like UBS, experts say

Delay of DOL fiduciary rule enforcement mechanisms now final

Supporter of regulation calls the postponement 'an effective repeal of the rule.'

UBS exits protocol for broker recruiting

Wirehouse is the second to dump the industry agreement that was created more than a decade ago to limit lawsuits against brokers when they leave firms.


Subscribe and Save 60%

Last News

best performing mutual funds of all time caterpillar hewitt john hancock retirement calculator tax on cash surrender value of life insurance schwab mutual fund transaction fee synthetic dividend dodge & cox income which is better taxact or turbotax prudential fmla postal retirement calculator irs afr rate t rowe price benefits aired on the side of caution what is the cost for h&r block tax preparation how much of dodd frank has been implemented conseco life insurance company phone number how much is clinton portis worth what is taylor swifts dads name rolling over a 401k to an ira buffalo wild wings ann arbor menu wells fargo insurance services charlotte nc t rowe price 401k terms and conditions of withdrawal which is better turbotax or taxact can you rollover 401k to roth ira jp morgan clearing corp dtc number t rowe price international small cap equity trust the hungry games parody how much does fdic insure per account best fidelity funds for 401k mojo in the morning salary crystal harris net worth wells fargo private bank requirements wells fargo cd rates best return mutual fund trustee to trustee transfer vs rollover franklin income class c vanguard intermediate bond etf