Understanding the Nature of 12b-1 Fees on Mutual Funds
In a mutual fund, 12b-1 fees are fees that your money plan manager collects from you and other shareholders for advertisements to get more investors.
The larger the number of shares a company has under management, the less it costs them to advertise because the cost is divided among everyone.
These fees may also be used for recordkeeping or administrative services.
What Composes 12b-1 Fees?
Generally, 12b-1 fees cover two kinds of expenses relative to an investor’s mutual funds. These are distribution expenses and service expenses.
The total 12b-1 fee charged to a fund is capped at 1% each year.
These expenses refer to expenses such as marketing and selling fund shares, delivering shareholder materials, and providing the toll-free phone number.
Distribution expenses are limited to 0.75% out of the total 1% capping for 12b-1 fees.
These expenses refer to activities that benefit fund investors such as compensating plan managers who look after their mutual fund accounts.
Service expenses are capped at 0.25% annually.
Why Do Investors Have to Pay For 12b-1 Fees?
12b-1 fees are included in the expense ratio for your mutual fund, which is a way for fund managers to cover costs such as advertising and administrative expenses.
To be competitive with other similar funds, some companies charge 12b-1 fees because it can help them acquire more assets under management (AUM).
This means they don’t have to spend money on marketing and advertisement anymore.
Example of 12b-1 Fees
Say, for example, a mutual fund has an average annual net asset of $20 million. A company charges 1% of the net asset as a 12b-1 fee.
This means that the 12b-1 fee is equal to $200,000.
If the company caps the distribution fee at 0.75% and the service fee at 0.25%, the distribution fee is equal to $150,000 and the service fee is $50,000.
Since these fees are paid to third parties, they’re not included in the published management fee for your mutual fund.
Avoiding 12b-1 Fees
One way to avoid paying these fees is by investing with a low-cost online broker where funds have no distribution or service fees.
Another strategy you can use is dollar-cost averaging, which lets you buy shares at regular intervals throughout the year so you don’t need to pay for another transaction.
Also, consider looking at a mutual fund’s expense ratio. The mutual fund’s prospectus will detail the fund charges for distribution and service expenses. Make sure you understand how they affect your return.
When it comes to 12b-1 fees, you have to decide what you’re willing to pay as an expense ratio for your mutual fund.
Since 12b-1 fees are not included in your management fee that’s published in the fund prospectus, it helps to read through the prospectus carefully.
As a rule of thumb, look out for funds that charge 12b-1 fees and aim to steer clear from them because eventually, these 12b-1 fees will eat up your returns.
If you do have funds that take away from your returns through high 12b-1 fees, remember that there are always other options available.
Contact a financial advisor or broker who can suggest low-fee alternatives for you.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.