BigDaddy U | 5 Mutual Fund Costs Every Investor Should Understand
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5 Mutual Fund Costs Every Investor Should Understand

5 Mutual Fund Costs Every Investor Should Understand

Mutual funds are a convenient way for investors to purchase a broad portfolio of stocks and bonds with a low initial investment requirement; mutual funds give investors access to high-quality money managers. The costs related to buying and holding a mutual fund can be difficult to identify, even for investors who read the fund’s prospectus. Here are five mutual fund costs that every investor should understand.

#1- Sales charge (sale load)

A sales charge, or sales load, is a cost you pay to purchase the fund, or the cost assessed when you withdraw funds. There are many different ways that a sales charge can be assessed, and that’s what causes investor confusion.

A front-end load, for example, is charged when you invest, so if your front-end sales charge is 3%, you’re charged $30 for an initial $1,000 investment in the fund. On the other hand, a back-end load is assessed when you withdraw funds, and this type of sales charge declines each year that the funds remain invested. Since mutual funds are designed for long-term investing, the declining sales charge rewards investors who stay invested longer.

#2- Annual expense

Mutual funds incur costs each year for accounting, legal and money management services, and the annual expenses cover these costs. The annual expense is assessed based on a percentage of assets under management, so the total dollar amount you pay increases as your investment portfolio grows.

Many mutual funds market themselves as “no-load” funds, which means that there is not a sales charge, but these funds do charge an annual expense to manage the fund each year. Some no-load funds have an annual expense percentage that is higher than the average expense for a load fund, so read the marketing information and prospectus carefully. Since the annual expense is assessed each year, the cost has a big impact on your rate of return over time.

#3- 12b-1 fee

This fee is an annual marketing or distribution fee, and it is also based on a percentage of assets under management. The bulk of this fee is used to compensate salespeople who sell mutual funds, monitor fund performance and answer questions for investors. FINRA, the organization that has oversight over the financial advisor community, limits 12b-1 fees to a maximum of 0.75% of assets under management.

#4- Interest and dividend income tax

If you use mutual funds in a retirement plan or some other tax-deferred account, taxes on bond interest and dividend income are deferred. However, if you invest in a taxable mutual fund, those distributions are taxed as income to you each year. While taxes are not a charge assessed by your fund, taxes are a cost, because your after-tax return (the money you put in your pocket) is lower. Your mutual fund will report your interest and dividend income each year.

#5- Capital gains tax

Investors in a taxable account are taxed when a mutual fund sells a stock or bond for a gain, and these are referred to as realized gains. You need a buy and a sell for a realized gain to be assessed, so buying a stock at $50 and holding it when the market price reaches $70 does not generate a realized capital gain.

The amount of capital gain tax you incur is impacted by the amount of portfolio turnover the money manager generates. If the portfolio manager trades frequently, you may incur more capital gains, as opposed to a portfolio with less trading. Keep in mind that capital gains are reduced by capital losses. The capital gains tax rates differ from the tax on income, and the tax rates change over time.

Mutual funds are a great way to purchase a diverse portfolio of stocks and bonds, but make sure that you understand the costs you’ll incur to buy and hold your mutual fund. These costs have a big impact on the rate of return in your portfolio over time.

 

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