Battle of the Share Classes: What’s Better for a Client After Taxes?

Another year of tax filings is now in the books. It’s the first official annual filing under Trump’s new tax law, which went into effect on January 1, 2018. Governed by new legislation, many individuals were impacted differently. From the corporate tax structure to state tax deductibles, there were several changes that likely impacted clients’ assets and their wealth planning. One of those changes eliminated the tax deductibility of fees paid to financial advisors (FAs).

While this might not be an obvious consideration for a client’s financial planning, it is certainly a change that could have a dramatic impact on the money that remains in your clients’ pockets.

Fee structures for FAs have evolved over the years. Faced with regulatory pressure and increased competition, many FAs migrated clients from a commission based-fee to an advisory-based fee, calculated based on the assets under management.

But under the new tax laws, it just may be in a client’s best interest to pay fees inside a mutual fund (in the form of a 12b-1 fee, for example), rather than pay this asset-based fee. The former provides a better after-tax outcome for the client than the latter. Paying an asset-based advisory fee is no longer deductible. But the expenses inside of a mutual fund are netted against performance and therefore tax deductible.

Take, for example, a client who invests $100,000 for one year in a mutual fund that earns a 10% return before any fees.

If the client is charged a 1% asset-based fee, and invested in a typical class I share with no commission or 12b-1 fee, he or she would pay a $1,000 fee after tax and earn a taxable $10,000 return. Assuming a 40% tax rate, the client would owe $4,000 tax on the $10,000 profit. The client would also have to pay the $1,000 fee with after-tax dollars meaning he would have had to earn $1.667 pre-tax to pay the fee ($1.667 - .40 x $1,667 = $1,000). This leaves $104,333 after tax ($110,000 - $4,000 - $1,667).