IRS clears up confusion over IRA account wrap fees

By Rick Miller

Mar 7, 2005 @ 12:01 am (Updated 12:00 am) EST

CHICAGO - The Internal Revenue Service may have given fee-based advisers the upper hand over their commissioned brethren when it handed down a private-letter ruling last month on the treatment of fees for individual retirement accounts.

Advisers say the IRS clarified a gray area when it ruled that a wrap or asset-based fee for an IRA can be paid with outside money - and not run afoul of contribution rules - as opposed to having to be paid with pre-tax dollars from the IRA. The rule also clarified that the wrap fee paid with outside money would be tax deductible.

"It does bring a lot of clarification to what is essentially one of the fastest-growing areas in how to work with IRA accounts," said Michael Kitces, director of financial planning at Pinnacle Advisory Group Inc., a Columbia, Md., firm with $360 million under management.

"We've had this [asset-based] fee structure that hundreds of major firms across the country have been using for several years and nobody really had any clear understanding about whether you were allowed to pay the fees with outside money," he said.

Before this ruling, the general practice was for companies to take the "stricter interpretation" by sweeping fees from the IRA accounts, including Pinnacle, Mr. Kitces said.

'A selling point'

Some investment advisers believe the private-letter ruling, though it doesn't create a legal precedent, gives them a competitive advantage over brokerage firms with commissioned-based pricing models.

"It is a selling point between using an adviser that has the ability to charge a fee as opposed to a brokerage-based adviser who is going to be earning commissions, because one is tax deductible and the other is not," said Loyd J. Stegent, a certified public accountant and certified financial planner who is director of financial planning at Cornelius Stegent & Price LLP in Houston.

Deciding whether to pay the IRA fee with outside money depends on the client's situation, but "at the very least, a percentage of asset-based advisers would have an edge because the client will have a choice, whereas with commissioned-based advisers there is only one road to choose," noted Mr. Kitces.

However, some of the major wirehouses and brokerage firms have offered fee-based pricing models for years. In fact, the private-letter ruling, cited as No. 200507021 and released Feb 18, likely came at the request of a large broker-dealer, advisers said, although the specific name is omitted in the published letter.

The company, whose request for a ruling was made in January 2001, said it was charging an asset-based wrap fee in several programs that provided a combination of investment advisory services and securities trading service for IRA clients.

The company wanted clarification from the IRS on whether the clients could pay these fees with outside funds without it being considered a contribution to the IRA.

The IRS' ruling determined these fees are more akin to a trustee fee - the annual fee IRA holders pay to the custodian - which can be paid outside the IRA and is tax deductible. That's not true of a broker's commission for trades within the IRA, since paying those with an outside fee would be considered a contribution to the account.

The Securities Industry Association of Washington and New York, which represents some 600 securities firms, called the private-letter ruling "a very positive step."

"Our firms believe that the availability of a wrap-fee account is very important to investors, and this ruling seems to remove a potential hurdle to wider use of these types of accounts," according to a prepared statement.

Several investment advisers interviewed, while glad to see a ruling, said they had already been practicing under the assumption that the asset-based fee was a deductible expense.

"We took the attitude that since a qualified plan can reimburse its fees for management fees and therefore get a deduction, there is no reason why somebody who reimburses his IRA wouldn't be allowed the same opportunity," said Mike Kresh, a CFP and president of M.D. Kresh Financial Services Inc. an Islandia, N.Y., firm with $60 million in fee-based assets under management.

Even as their clients have a choice, paying the IRA fee from a taxable account does not always make sense, advisers said. For example, wealthy clients who come under the alternative minimum tax would not be allowed to deduct investment management fees, and are better off paying the fee with pre-tax money, adviser said.

Marilyn R. Bergen, a CFP and co-president of CMC Advisers LLC in Portland, Ore., said in 90% of the cases, her firm recommends that the advisory fee be paid using pre-tax dollars.

Keith Newcomb, a financial planner and wealth manager who operates Full Life Financial LLC in Nashville, Tenn., called the impact of the private-letter ruling "profound," especially when one considers the benefit of being able to keep funds growing tax-deferred in the IRA.

To quantify the difference, Mr. Newcomb ran a hypothetical analysis of a 50-year-old client with a $1 million IRA. Assuming the client had a rate of return of 8%, paid a 1% annual fee and was in a 30% tax bracket, Mr. Newcomb calculated that after 20 years, the account would grow to $4.94 million if the fee was paid from outside the account, compared with $4.06 million if paid from within the account.

To make it an apples-to-apples comparison, he created a side account to factor in the retained fee in one scenario and the tax deduction from the other. The side account, with a 6% after-tax rate of return, would grow to about $634,000 if the fee is paid within the IRA, and about $209,000 if paid outside. After 20 years, if the client uses outside funds, the combined balance of the IRA and side account comes out $456,000 higher.

"A planner that suggests that maneuver is going to earn his fee, I should think," Mr. Newcomb said.