Mutual funds are a great way to invest in the markets. They allow you to diversify your holdings with a small initial investment. The costs you pay for a mutual fund has a huge impact on the rate of return you earn. Nothing is more frustrating than to find out that your earnings have been “eaten up” by fund costs. Use these tips to reduce the cost of your mutual fund.
The impact of taxation
For starters, keep in mind that the largest “cost” of owning a mutual fund is annual taxation. Your mutual fund may incur taxes on three types of transactions:
- Interest income on bond holdings
- Dividend income on stocks
- Capital gain taxes on securities sold for a gain
A quick word on capital gains: Investors are taxed on realized gains. A realized gain means that you have a buy and a sell of a security. If you buy IBM common stock at $30 a share and the stock now trades at $60, you have a $30 per share unrealized gain. The unrealized gain is not taxed.
Fund tax-deferred investments first
Generally, “retirement plans” are tax deferred. That means that the investor is not taxed until dollars are withdrawn (presumably for retirement income). Try to maximize your investments in tax deferred investments first- then invest addition dollars in funds that are taxed each year.
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Many funds have a sales charge (or sales load). This charge compensates an investment advisors for selling the fund and monitoring the investment for a client.
Sales charges can really cause confusion for investors, because the charge can be assessed in many different ways. You can pay the charge on the front-end (when dollars are invested) or on the back-end (when you withdraw dollars).
Take the time of review your funds summary prospectus. You can download this document from the fund’s website. Here’s an example for American Fund’s Washington Mutual stock fund- a fund that’s been around for years. The prospectus will compare the total sales charges you’ll pay, based on a variety of scenarios.
If, for example, you plan on holding the fund for 7 years or more, you may find that the back-end load decreases to nearly zero. This is intentional: The sale charge is set up to encourage the investor to hold the mutual fund over the long term.
As the name implies, annual expenses are charged to manage the mutual fund each year. This expense pays for the analysts, accountants, lawyers and other admin staff.
This brings up another area of confusion. Many funds are “no-load’ mutual funds. They do not require a sales charge. However, nearly all mutual funds charge an annual expense. The amount of that expense can vary greatly.
The annual expense lasts forever- as long as you own the fund. So, the dollar amount of that expense has a huge impact on your rate of return over the life of the fund. Again, check the summary prospectus for the annual expense amount- and how that cost compares with similar funds.
A breakpoint is a quantity discount. You earn a breakpoint by investing in a particular fund family. American Funds, for example, is a fund family that manages dozens of mutual funds. If you choose to diversify your holdings by using a variety of American Fund products, you will receive a discounted sales charge.
Finally, consider using Morningstar for your mutual fund research. This site has great information on all aspects of mutual funds- including the impact of taxes on the rate of return of your fund.
Use these tips to make smart decision about the cost of your fund. These decisions will help you minimize the cost of your mutual fund. Those decisions can have a massive impact on your earnings over time.
How have you handled your decisions about mutual fund investing? I’d love to hear from you.
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