The Rap On Wrap Fees For Retirement Accounts

Because of their flat fee - which eliminates the problem of overtrading by commission-seeking brokers - fee-based accounts, also known as wrap or managed accounts, are rising in popularity. If, however, your retirement account is managed under a wrap-fee program, you need to be sure such a program is suitable for you. But you also need to consider whether you should pay the fee out of your retirement account balance or out of pocket. Here we look at the advantages of the second option and tips on how to do it. (If you are interested in reading more about wraps, see Introduction to Fee-Based Brokerage Accounts and Wrap It Up: The Vocabulary And Benefits Of Managed Money.)

The Question: To Pay Wrap Fees Out of Your Balance or Your Pocket?
Your first consideration in answering this question is how paying out of your retirement balance decreases the return on your retirement account investments. Next, you want to be aware of the potential tax benefit of paying out of pocket.

The Disadvantage of Paying from Your Account Balance
Paying wrap fees from your retirement account means that the fee reduces your account balance. This, in turn, reduces the amount of assets that continue to accrue earnings on a tax-deferred basis, or a tax-free basis in the case of Roth IRAs. Overtime, this reduction in the balance can have significant impact on the overall performance of your retirement-account investments.

For example, say you have a wrap account that earns a return of 10% and charges a fee of 1%. By paying your wrap fees out of your retirement-account balance, you decrease the return on your investment by 8% over a five-year period. The chart below illustrates this decrease. It shows the yearly difference in return over a five-year period for an investor who starts with an IRA balance of $1 million, and on which he or she gets a return of 10% and pays a 1% wrap fee per year. You can see how dramatically the 1% fee affects the yearly return.

Starting Balance $1,000,000
Fee paid from account Fee paid from outside account
Earnings Fee Balance Earnings Fee Balance
Year 1 100,000 10,000 1,090,000 100,000 10,000 1,100,000
Year 2 109,000 10,900 1,188,100 110,000 11,000 1,210,000
Year 3 118,810 11,810 1,295,100 121,000 12,100 1,331,000
Year 4 129,510 12,951 1,411,659 133,100 13,310 1,464,100
Year 5 141,165 14,165 1,538,659 146,410 14,641 1,610,510

Table 1

In this example, after five years, the total difference in the retirement account balance is $71,851, and this amount will increase each year!

TIP: If you nevertheless decide to pay wrap fees from your account balance, remember these payments are not treated as distributions and are therefore not added to your income. As such, be sure not to include these payments on your tax return.

The Potential Added Advantage of Paying Out of Pocket
Paying your wrap fee out of pocket not only sustains the rate of return on your retirement account investments, but may also allow you to receive a tax deduction for the wrap fee payment.

In order to receive this benefit, you must claim the amount as an itemized deduction on Schedule A of Form 1040 (your tax return), and the fee must be in excess of 2% of your adjusted gross income (AGI). (This 2% floor is applicable to all itemized miscellaneous deductions.) If the amount meets the 2% requirement, you may claim the amount of the wrap fee that is more than 2% of your AGI. Bear in mind that in making tax deductions, you can either use a standard deduction or itemize your miscellaneous deductions. If the standard deduction is more advantageous for you, then the deductibility of the wrap fee is irrelevant. For additional information, refer to IRS Publication 529 and the instructions for filing Form 1040.

Weighing the Benefit of Using Out-of-pocket After-Tax Assets
If you are not eligible for the deduction of wrap fees, you must consider whether it is beneficial to use out-of-pocket assets, which are likely already taxed, to pay the fees. Paying from the balance reduces the return on your tax-deferred assets; however, to determine the ultimate effect, you should consider the taxes that may apply to this difference.

For instance, in the example demonstrated by Table 1, paying out of pocket results in an increase of $71,851 in the account balance. However, when this amount is eventually distributed from the retirement account, it may be subject to income tax at your applicable tax rate - the higher account balance could mean higher taxes. This depends largely on the type of IRA you are holding in the wrap. If the account is a Roth IRA, the distributed amount will be tax free (if qualified). Therefore, for a Roth IRA, paying out of pocket seems to be the more advantageous option, but for other retirement accounts, this may not be the case. Both options should be carefully weighed.

Does your Retirement Account Provider Allow Payments out of Pocket?
A long-standing debate on whether wrap fees can be paid out of pocket was addressed by the IRS in the private letter ruling (PLR) 200507021. The debate was centered on whether commissions (which is part of a wrap fee) for a retirement account could be paid out of pocket. The debate also questioned whether, under current regulatory guidelines, such payment would be treated as a contribution to the retirement account. In PLR 200507021, however, the IRS concluded that such payment would not be treated as contributions to the retirement account.

As a result of this PLR, many retirement-account services providers that were hesitant to allow wrap fees to be paid out of pocket are now doing so. If you maintain a wrap account, check with your service provider to determine their position on the matter.

Caution: Pay Fee Before It Is Debited
While the IRS allowed the wrap fee to be paid out of pocket under PLR 200507021, it did not address the existing rule disallowing the reimbursement of fees paid from the retirement account. Therefore, if you want to pay your wrap fee out of pocket, check with your retirement-account provider to determine if they offer a billing service or other provision to allow you to pay the fee before it is debited from your retirement account.

Generally, if your provider offers a billing service, you receive an invoice for your wrap fee, which will include a deadline by which the payment must be made. If you fail to make your payment by the stated deadline, the fee is generally debited from your retirement account. And, if you send in your fee after the payment has been debited, then the payment is considered a contribution, which is subject to the applicable limit. The possible effect of a late fee payment is an excess contribution to your retirement account. (For dealing with these contributions, see Correcting Ineligible (Excess) IRA Contributions.)

An Example
John, who\'s 45, sent in a check for $5,000 for his wrap fee to his IRA provider, who received it after the wrap already debiting John\'s IRA. Since the payment was received after the fee had been debited, the IRA provider deposited the check as an IRA contribution. However, John had already made a contribution of $4,000 to his IRA, the $5,000 late payment resulted in an excess contribution.


When deciding whether you should pay your wrap fee from your retirement account balance, the main factor to consider is the impact of paying from the account has on the investment return. Consider also how the reduction in return affects your intended purpose for the funds: will it be used to finance your retirement years or left as inheritance to your beneficiaries?

If you decide to pay the fee out of pocket, be sure to take into consideration whether you are eligible to receive a tax deduction for fees paid out of pocket. Also remember to weith the ultimate effect paying out of pocket has on the taxes you may pay on the amount. Equally as important, check with your retirement account provider to determine whether they offer such a service, as well as the policies and procedures which apply. As with anything that has to do with financial planning, consult with a competent financial services professional to determine the options that are most suitable for your financial profile.