The short answer to this question is "No, you cannot deduct fund expense ratios on your tax return." However, while these expenses aren't directly deductible, the reasoning behind this makes sense when you understand the Internal Revenue Service's definition of an investment expense. Here are the rules on deducting investment fees and expenses and why expense ratios don't count.
Investment fees and expenses are deductible -- sometimes
According to IRS Publication 529, investment fees and expenses are among the miscellaneous deductions you can use to the extent that they exceed 2% of your adjusted gross income (AGI). They fall into the same tax category as other miscellaneous deductions such as:
- Unreimbursed employee expenses
- Tax preparation fees
- Casualty and theft losses
- Losses on deposits
- Safe deposit box rent
Basically, if you add up all of the allowable miscellaneous deductions subject to the 2% limit and then subtract 2% of your AGI, you can deduct that amount on your tax return.
So, why are expense ratios not deductible?
Take a closer look at the IRS' wording:
You can deduct investment fees, custodial fees, trust administration fees, and other expenses you paid for managing your investments that produce taxable income.
This certainly includes some investment expenses. For example, if you pay a fee to your financial advisor (not a commission), it is deductible. So are subscriptions to investment newsletters and publications if they help you manage your own investments.
However, expense ratios are not included simply because they don't meet the criteria of an expense paid that produces taxable income. When you receive your income from the fund, the expense ratio is already deducted -- it's not a fee that you pay directly. In other words, if one of your funds has a 1% expense ratio and produces an 8% return on its investments this year, the value of your investment will only increase by 7%. You would only owe taxes on that 7% (if you sell), so the expense ratio wouldn't be deductible.
Another common misconception
Similarly, it's worth mentioning that brokerage commissions are also not deductible expenses -- a common myth among investors. Rather, the commissions you pay are included in your cost basis. If you pay $2,000 for a stock investment and sell it for $3,000 with a $10 commission each time, your cost basis for calculating taxable gains will actually be $2,020. So, you pay taxes on your profits excluding the commissions.
In a nutshell, expenses you directly pay for investment services or tools that help you manage your own investments are deductible, to the extent that your miscellaneous deductions exceed 2% of your AGI. However, if an investment expense is already deducted from your profits, it is not.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!