Understanding Wrap Fees for Retirement Accounts

Fee-based accounts—also known as wrap or managed accounts—are rising in popularity. These typically impose an annual percentage fee based on the amount of assets under management, which eliminates the problem of overtrading by commission-hungry brokers. However, If your retirement account is managed under a wrap fee program, you need to consider whether you should pay the fee out of your retirement account balance or out-of-pocket.

The Impact on Your Account Balance

Your first consideration is how paying the fee out of your account balance decreases the return on your investments.

Those wrap fees reduce your account balance. This, in turn, reduces the amount of the assets that continue to accrue earnings on a tax-deferred basis, if it's a traditional IRA, or on a tax-free basis, if it's a Roth IRA. Over time, this reduction in the balance can have a 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, 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, gets an annual return of 10%, and pays a 1% wrap fee per year. You can see how dramatically that 1% fee, small as it sounds, affects the yearly return.

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

The Downside of Paying out-of-Pocket

Next, you want to be aware of the potential tax impact of paying out-of-pocket, meaning using money that has already been subject to income tax to pay the fees.

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 will be subject to income tax at your applicable tax rate, assuming it is a traditional account, not a Roth. The higher account balance would owe more taxes. So the answer 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. Paying out-of-pocket seems to be the more advantageous option. But for traditional retirement accounts, this may not be the case.

Is It Allowed?

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 centered on whether commissions (which are 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, the IRS concluded that a wrap fee 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.

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 get 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. If you send in your fee after the payment has been debited, the payment is considered a contribution, which is subject to the applicable limit.

An Example of Using Wrap Fees

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 debited 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.

The Bottom Line

When deciding whether you should pay your wrap fee from your retirement account balance, the main factor to consider is the impact on the investment return.

If you decide to pay out-of-pocket, check with your retirement account provider to determine whether they offer such a service and exactly what policies and procedures apply.