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Roth IRA > Strategies

Dealing with Wrap Fees

A ruling released in February 2005 provides flexibility.

People who have large IRAs sometimes invest them in programs that charge an overall fee, called a wrap fee, that covers investment advisory services, trading costs and other services provided in managing the account. A ruling released in February 2005 makes it possible for the IRA owner to pay these fees with money outside the IRA account, preserving more money within the IRA.
 

Caution: The ruling described on this page is a private letter ruling. Such rulings let us know what the IRS thinks about a particular issue, but the only taxpayer allowed to rely on the ruling is the one who requested it.

Inside, Outside

According to the IRS, different types of IRA fees require different treatment:

  • Brokerage commissions incurred to buy and sell stocks are considered an expense of the IRA itself. If you pay these commissions with funds from outside the IRA, you're considered to be making a contribution to the IRA, even if the money went directly to the broker. You'll incur an excess contribution penalty if these deemed contributions put you over your contribution limit for the year.
  • An annual maintenance fee charged by the IRA provider is not required to be treated as an expense of the IRA. You can pay this fee with funds from outside the IRA without having the IRS treat you as making a contribution to the IRA. In fact, if you pay this fee outside your IRA, you're allowed to claim an itemized deduction, subject to the 2% floor that applies to miscellaneous itemized deductions.

Wrap Fees

Some companies offer accounts in which all services are covered by a single fee, appropriately called a wrap fee. This fee covers everything, including annual maintenance charges and brokerage commissions. That raises the question whether these fees can be paid with money from outside the IRA without causing a deemed contribution. In February 2005 the IRS released a private letter ruling that describes several different types of wrap accounts and concludes in each case that the wrap fees can be paid with outside money.

Example: You place your $400,000 IRA with a company that agrees to cover all expenses with a fee equal to 1.5% of the account balance. If the fee is paid from IRA funds, your IRA balance will be reduced by $6,000. If the IRS ruling applies, you can choose instead to pay the $6,000 fee with money from outside the IRA. You will not be treated as if you made a contribution to the IRA, even though your payment preserved the IRA balance, and even though it is used in part to cover brokerage expenses.

The key to the ruling appears to be that although the wrap fee covers brokerage expenses, it does not vary according to the size of the brokerage expenses. If you happen to have no brokerage expenses at all in a particular year, you'll still pay the same wrap fee.

Deducting the Fee

The ruling doesn't say anything about whether the wrap fee is deductible. There doesn't appear to be any reason to treat this fee differently from an account maintenance fee, however. That means you should be able to claim a deduction if you use money from outside the IRA to pay the fee. You have to itemize to claim the deduction, and some or all of the deduction may be lost due to the 2% floor for miscellaneous itemized deductions.

Roth IRA

This ruling potentially provides rich benefits to owners of Roth IRAs. Using funds outside your Roth to pay a wrap fee will preserve a larger balance in your IRA, increasing the amount of investment earnings that can accumulate tax-free. It's like being allowed to make an additional contribution. Earnings on that "contribution" will be tax-free for as long as the Roth exists, which may be decades. That's a rich benefit, even if you can't claim a deduction for this expense. If you can deduct it, the payment produces a rare trifecta: a current deduction, tax-free earnings, and no deferred taxation.

Traditional IRA

You can benefit with a traditional IRA as well, but here you have a trade-off. Using money from outside the IRA to pay the wrap fee increases the amount that will eventually be taxable when you draw down the account. If you don't benefit from claiming an itemized deduction for the wrap fee, you're creating a situation that's equivalent to making a nondeductible contribution to the IRA, but without getting any basis for the contribution.

Example: You pay a $6,000 wrap fee for your traditional IRA with funds from outside the IRA. Your tax situation that year is such that you can't benefit from claiming this item as an itemized deduction. The following year you convert the IRA to a Roth. As a result of having paid the wrap fee with outside money, you increased the size of your traditional IRA. That means the taxable amount of the conversion is larger. You pay more tax on the conversion, even though you didn't claim a deduction for the wrap fee.

You can still benefit from using outside money to pay wrap fees for a traditional IRA, particularly if you don't expect to draw down the account, or convert it to a Roth, for many years. You'll be allowing the account to grow more rapidly, with all the advantage that comes from tax-free compounding within an IRA. You should be cautious about using this idea with a traditional IRA when you can't benefit from deducting the wrap fee, however.

The Ruling

The ruling described here is PLR 200507021. Click here for the PDF file.

   





   

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