Many physicians work with a financial advisor to manage their money but don’t realize that in some cases the fee you are paying an advisor might give you a tax break.
Let’s take five scenarios and see how you could lower your taxes and net advisor fees.
1. Hiring a strictly commission-based financial advisor
A commission-based financial advisor receives compensation from the sale of financial and investment products. Most physicians have no idea what they’re paying these advisors because of lack of transparency and conflicts of interest. Rule of thumb: If you don’t get an invoice from your financial advisor, he might not be acting in your best interest and might not be a fiduciary.
Let’s say your commission-based financial advisor sells you $10,000 of a mutual fund with a 5% commission (called a load). You’ve paid $500 as the load and your investment is worth $9,500, but the load is not tax deductible. Instead that cost is “capitalized.” This means that later if you own the fund in a taxable account and sell the fund for $11,000, your gain is $1,000 not $1,500, resulting a in a lower capital gains tax.
2. Hiring a fee-only financial advisor who manages only a taxable account
In contrast, if you hire a fee-only financial advisor who charges you directly and does not sell you products for a commission, you might be able to deduct the fee on your tax return. Suppose you only have a taxable investment account and your advisor charges you $5,000 to manage that account annually. Whether or not that fee is tax deductible depends on your income—specifically your adjusted gross income (AGI), which is your income after certain deductions. Only the portion of the fee greater than 2% of your AGI may be deductible. So if your AGI is $200,000, then only $1,000 out of the $5,000 fee may be deductible (2% of $200,000 is $4,000, and that is not deductible). I say “maybe” because you must itemize deductions on Schedule A of your tax return, and even if you do so, this deduction might be wiped out if you are subject to the alternative minimum tax (AMT).
3. Hiring a fee-only financial advisor who manages only tax-deferred accounts
This is a more common scenario because many emergency physicians only have tax deferred accounts such as SEP IRAs and traditional IRAs. In this case, you have two options: (1) pay the fee by writing a check from your personal checking account, subject to the 2% rule mentioned before or (2) have your advisor deduct the fee from the tax-deferred accounts. In the second case, you are using pre-tax dollars to pay the fee so in effect you get the full deduction. The difference is that in the second case you cannot report that on your income tax return. Instead you get the tax benefit later on when you withdraw money from your account during retirement.
4. Hiring a fee-only advisor who manages a combination of taxable and tax-deferred accounts
This is where it gets even trickier. You’ve got two choices: (a) pay the entire fee from a taxable account or personal checking account or (b) have the portion of the fee attributed to the tax- deferred accounts deducted from those accounts and pay the rest from the taxable or checking account. Which one you choose depends on calculating the maximum tax benefit. If your income is really high and you cannot get any deduction on your current tax return based on the 2% rule, then you’re probably better off going with option b.
5. Hiring a fee-only advisor who manages your corporate retirement plan account
If you are self employed, have formed a corporation, and have set up an individual 401k plan sponsored by your corporation, you might be able to claim the portion of the fee attributed to the management of the individual 401k as an expense in the corporation. Be careful here — you’ve got to run this by your accountant to see if he agrees with this or not.
One last word – don’t hire a financial advisor just so you can claim another deduction on your tax return. Instead the reason to work with an advisor is the value he can bring to you even if you get no tax deduction at all for the fee.