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.
According to the IRS, different types of IRA fees require
- 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.
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.
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.
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
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
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
The ruling described here is PLR 200507021. Click
for the PDF file.