Did you know that expenses incurred in the production of income are deductible? Congress granted the deduction and then promptly buried it (it's actually on line 27 of Schedule A). Investment expenses are grouped into two categories:
- All of the outrageous mutual fund load and back-end fees, trading costs to purchase or sell specific securities (also outrageous unless you use a discount broker), and any other expense or payment that is specifically tied to the purchase or sale of a specific security.
- General production-of-income expenses (e.g., account maintenance fees, investment advisory fees) as well as the more general expenses associated with investment decision making (e.g., subscriptions).
Type 1 expenses -- those associated with the purchase or sale of a specific security -- are not deductible. Instead, these expenses are added to the taxpayer's purchase basis or netted against sale proceeds, as the case may be. So, when you purchase 100 shares of Cedar Fair (NYSE: FUN ) at $32 and your broker charges you $128 in commissions (because you haven't switched to a discount brokerage... yet), the $128 is not deductible. Instead, the $128 is added to the $3,200 cost basis of your 100 shares. Furthermore, when you sell the shares, the commission is subtracted from the proceeds. If you paid another $128 to sell your shares of Cedar Fair at $40 apiece, you'd subtract $3,328 (your cost basis) from $3,872 (your $4,000 gain minus the $128 commission), giving you a taxable gain of $544.
Type 2 expenses -- those that result from the general production of income not associated with the purchase or sale of a specific security -- are deductible. However, they are subject to a 2% adjusted gross income floor, which inevitably will remove some portion of your itemized deduction. Further, in order to deduct these expenses, a variety of tests must be met:
- The taxpayer must itemize deductions using Schedule A of Form 1040. Unfortunately, no deduction is allowed here for short form or standard deduction filers.
- The expense must be literally "paid or incurred" by the individual taxpayer. If you pay it, you get to deduct it! While that sounds straightforward, here's a piece of news: You don't own your individual retirement account (IRA)! That's right. You control it, you are the beneficiary, but your trustee owns it. Therefore, if you have advisory fees deducted from the IRA account, there are no deductions. However, if you pay those same fees out of your pocket, the deduction is yours. (If you want to do this, contact your IRA custodian/trustee and fill out their paperwork to elect this option.)
- Bad advice is still deductible. Some advice is good, and results in current or future income ("She told me to buy Johnson & Johnson (NYSE: JNJ ) "). Some advice is bad, and results in losses ("He recommended I buy Lucent (NYSE: LU ) "). When it comes to deducting investment expenses, there is no requirement that the expense actually result in any income.
- The expense paid or incurred must be considered "ordinary and necessary." For the expense to be deductible, the relationship between the expense and the production of income need only be "reasonable and proximate." It need not be direct and it need not be allocated or apportioned.
Some examples of deductible expenses are:
- Good investment advice (such as a subscription to the Rule Your Retirement newsletter service).
- Software or Internet subscription for an intraday online quotation service.
- Investment magazines.
- Annual account maintenance and distribution fees.
- Expenses associated with filing your "proof of claim" on Enron. This is the form you would sign to join with all the other Enron shareholders hoping a bankruptcy court judge will award you some money (unlikely) or a billionth of 1% interest in Ken Lay's ski condo (ya never know).
- Depreciation on your home computer that you use exclusively (or at least predominantly) for online trading, tracking of investments, etc.
Here are some examples of expenses that are not deductible:
- Any fee or expense from above that you didn't pay.
- Generally, the cost of attending any investment seminars (typically in warm places, usually on a big device that floats on the water).
- An expense that would otherwise be considered ordinary and necessary, but is used in the production of tax-exempt income. Remember that IRAs and other deferred accounts are "tax deferred," not tax exempt.
The big one
Many taxpayers choose to hire an investment advisory service that charges a fee based on assets under management, typically in the range of 1% per year. If you have such a relationship and have a $1,000,000 IRA, this amounts to $10,000 per annum in advisory fees on your IRA. You can pay the $10,000 directly, in which case the $10,000 is deductible as a miscellaneous itemized deduction subject to the 2% adjusted gross income floor on Schedule A. This option can potentially reduce your federal income tax due in the range of $2,500 or more, depending on your marginal tax bracket as well as other miscellaneous deductions. Want to double up? Make a deal with your investment advisor and pay two years' worth of advisory fees in one year and save $5,000 or more in taxes.
Fool contributor William Stecker is a Certified Public Accountant who retired at age 47 after decades in accounting, finance, and related fields. He does not own any of the companies mentioned above. The Motley Fool isinvestors writing for investors.