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Updated on Tuesday, December 18, 2018
When deciding how to invest your money, it’s important that you choose your portfolio carefully. Besides picking what kinds of stocks, exchange-traded funds (ETFs) and mutual funds to invest in, you also need to consider the fees the different options charge. While many investments have fees, they can vary a great deal. Choose the wrong one, and the fees could eat away at your returns.
One of the most common fees is the 12b-1 fee, but it’s a fee you’ll encounter only if you make certain types of investments. Below, find out how 12b-1 fees work, how they can affect your returns and how to avoid them.
What are 12b-1 fees?
When you have a limited amount of money to invest, opting for mutual funds over individual stocks can make a lot of sense. Mutual funds are investment vehicles that are made up of many individual stocks and bonds rather than just one.
Actively managed mutual funds employ a manager who oversees the fund, deciding which investments to buy, sell and hold. Mutual funds allow you to diversify your portfolio, giving you more protection than investing in just one or two companies.
While mutual funds can be a smart investment strategy, they often have fees you should know about. Managing a mutual fund has costs, including transaction fees and operational expenses. One of the more common fees is a distribution fee known as 12b-1.
A 12b-1 fee is paid by the fund — using fund assets — to cover the costs of marketing and selling the fund, shareholder services (such as answering investor inquiries) and sometimes even employee bonuses.
According to the Investment Company Institute, 12b-1 fees have been around since 1980, when the Securities and Exchange Commission (SEC) installed the fee as a way to help investors. The fee was instituted to market mutual funds and, in theory, to increase assets and potentially decrease expenses.
Funds that charge 12b-1 fees believe they help increase a fund’s value through marketing and building demand. However, whether that’s true is up for debate. Critics say 12b-1 fees do nothing to increase the value of a fund or boost its demand, making the fees feel like an unnecessary upcharge.
12b-1 fees: the cost to investors
12b-1 fees can vary a great deal from fund to fund, but the SEC has set caps on how much companies can charge. All told, the fee cannot exceed 1% of the fund’s average net assets.
- Fees used to pay for marketing and distribution expenses cannot exceed 0.75% of the fund’s average net assets per year.
- Fees used to cover shareholder services cannot exceed 0.25% of the fund’s average net assets per year.
According to Robert Schultz, a certified financial planner with NWF Advisory Group in Los Angeles, a 1% fee may sound small, but over time, it can significantly affect the growth of your investment.
“12b-1 fees come directly out of the returns,” Schultz said. “The higher the fee, the worse off the investor.”
For example, say you invested $100,000. Assuming a 4% annual return and a 1% annual 12b-1 fee, your investment would grow to $180,000 over the course of 20 years. Sounds great, right? Not so fast.
If your fee had been only 0.25%, your investment would be worth $210,000. The higher fee would cost you $30,000 in market growth.
To find out what 12b-1 fees your fund charges, Schultz recommended doing some homework. “Investors should review the prospectus,” he advised.
If you’re not sure where to find it, contact your broker or investment manager directly and ask for it. The prospectus is a legal document filed with the SEC that outlines the details of the mutual fund. There can be many different fees listed, including redemption fees, exchange fees, purchase fees and account fees.
How to avoid 12b-1 fees
While 12b-1 fees can eat into your returns, it’s important to know that not all mutual funds charge these fees. It’s possible to find mutual funds that don’t charge them at all.
“Not all mutual funds charge 12b-1 fees, and some that do credit it back to the client,” said Schultz.
A fee-based fund, which charges a flat fee for advice or management services, often will credit the fee back to the client since it already charged a fee. If you need minimal advice or management help, a fee-based investment may be a smart option for you.
Another option is to invest in ETFs or index funds that don’t require active management. That way, you can avoid 12b-1 fees altogether.
Some mutual funds charge 12b-1 fees. While they’re relatively low, they still can have a significant impact on your net returns. If you’re looking for your money to grow as much as possible, avoiding 12b-1 fees can improve your investment returns over time.
If you need help choosing an investment strategy, a financial planner can be a huge help. If you don’t know where to start, check out our guide on how to choose a financial planner.
The “Find a Financial Advisor” links contained in this article will direct you to webpages devoted to MagnifyMoney Advisor (“MMA”). After completing a brief questionnaire, you will be matched with certain financial advisers who participate in MMA’s referral program, which may or may not include the investment advisers discussed.