Retirement Mutual Funds

Mutual Funds (and Costs) Explained

Mutual funds are investments set up to manage a pool of money from various investors. When you have mutual funds in your retirement account, you have no control of the investments within the funds and your assets are mixed with those of other investors. You share in the gains proportional to your contributions to the fund. Many different types of mutual funds are available, each with their own types of costs, which can make it a challenge to select one appropriate for your retirement.

There are two broad categories of mutual funds: open-end and closed-end. Open-end mutual funds have no restrictions on the number of shares they can issue to investors. If demand for the fund increases, the fund will buy more of the underlying investments. The value of each share is based on the market value of the fund’s underlying assets, or net asset value (NAV). A closed-end fund, on the other hand, has a fixed number of shares.

Within these categories, different mutual funds have different costs and fees, most of which you can find in the fund’s prospectus or annual reports. Some of these fees may be paid out of the fund’s assets, which can make these fees easier to overlook. Keep in mind fees are usually charged as a portion of the fund’s assets, which means the dollar amount of your fees can rise and fall with the market. Here are some of the fees you should be aware of:

Sales commissions/loads. These are paid to brokers/salespeople who find investors to buy shares. No-load funds and load funds impose different fees for commissions. When you select mutual funds for your 401(k) or other retirement account, you may notice funds with the same name but with different classes of shares. When and how these fees are charged depends on the share classes:

A shares: Charge sales fees or “load” up front.
B shares: Charge sales fees when investors sell. This is known as a “back-end load.”
C shares: Charge sales fees annually, known as a “level load”.

These different share classes refer to agreements between the fund company and the fund’s distributor, which could be a broker, adviser or retirement plan. Depending on which share class you own, you will pay different prices for the same fund.

Trading costs. Similar to individual investors paying commissions when they buy and sell shares, mutual funds have to pay fees to brokers when they rebalance their portfolio or liquidate assets to pay out redemptions. As a mutual fund shareholder, you will have to pay your share of those fees as well as taxes on any realized capital gains.

Management fees. Every fund has a manager who needs to get paid. As a shareholder, you will have to pay a percentage of your total assets toward management fees.

12b-1 fees. These are charged to fund shareholders to cover distribution costs, marketing costs and sometimes shareholder services. You are charged for these fees for as long as you hold the shares. Again, each share class can charge a different amount.

Expense ratios/total annual fund operating expenses. These combine all of the fund’s associated fees, including administration fees, management fees and other recurring annual fees, and are calculated as a percentage of your investment.

Tax Considerations

Mutual funds buy and sell shares throughout the year, and you have no control over fund transactions. If the fund racks up capital gains, you are held accountable for the associated taxes. Since you aren’t the one buying and selling, you have no control over when the fund distributes capital gains to its shareholders.

Assets are often sold to cover investor redemptions or to rebalance portfolios. This can result in commissions, which you will be partly responsible for and could affect your realized short- and long-term capital gains. Because capital gains are distributed to the mutual fund’s individual shareholders, you could end up paying taxes on these gains even if you don’t sell any shares, or even when the overall fund incurs a loss. You can lose money and still have to pay taxes!

You could avoid some of these tax pitfalls by purchasing mutual funds through a tax-advantaged account such as a 401(k) or IRA.* But you may wish to roll over mutual funds into a taxable account, and that could expose you to more taxes.

A Better Solution

You may be sacrificing returns and tax efficiency when using mutual funds in a retirement account. If you are a high net worth investor, a personalized, separately managed portfolio might better meet your investment objectives. By purchasing securities directly, you have more flexibility to tailor your portfolio to your specific needs while still achieving the diversification mutual funds provide. With this option, you can customize the buying and selling of securities according to your tax preferences. As your assets grow over the years leading up to retirement, your tax situation will likely become more complex. At this point, it is a good idea to consult a tax professional to better understand the specifics of your situation.*

Takeaway: The extra fees, lack of flexibility and tax implications of mutual funds in a retirement account could be eating into your retirement income. To learn more, request our “5 Pitfalls of Mutual Funds” guide or schedule an appointment with one of our professionals.

*The contents of this article should not be construed as tax advice. Please contact your tax professional.

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