Before or After Tax, that is the Question

Should I Keep Contributing to my Pre-Tax Retirement Account Even if I will be in a High Tax Bracket in Retirement? 

A high income couple I met with this week asked me this question.  Of course, the quick answer from financial advisors is that it is always better to pay tax later, rather than to pay tax now, and we generally assume that people will be in a lower tax bracket in retirement than they are at the peaks of their career.  But for individuals who have been diligent savers and have accumulated very large amounts of money in their IRA and 401k accounts, or who expect large payments from defined benefit pension plans, the math might be a little different.  Since these accounts must be distributed as taxable income during the saver’s lifetime, large account balances will inevitably result in large taxable incomes in retirement.  So is it a good idea to keep plowing money into tax deferred retirement accounts?

I wasn’t sure, so I ran my own spreadsheet analysis to understand how the numbers work.  The answer appears to be YES, the pre-tax savings will still win.  Consider how the math works.

Lets assume a high income earner in the 35% tax bracket is able to defer $100,000 into a combination of tax deferred vehicles.  That entire $100,000 starts to grow at an average 7% per year.  In ten years, the account will double in value, and be worth $200,000.

Lets say another investor opts to take the taxable income and invest the after tax proceeds.  He nets $65,000 after tax, and invests that $65,000 at 7% (for simplicity lets assume all capital appreciation here – no taxes until the investment is sold).  The account will grow to $130,000 in 10 years.

So far, the tax deferred approach is clearly winning.  But lets say that at this point the saver is required by law to start taking taxable distributions from the account, even though he really doesn’t need the money for living expense.  And lets further assume that he has numerous retirement income sources and so is still in the 35% tax bracket.

Assuming that he now pays the 35% tax on the required distributions, and reinvests the proceeds into an after tax account – the total value of his after tax and pre-tax accounts remain higher than the other investor who paid the tax up front.  Why?  The power of compounding, that’s why.  The larger starting balance in the tax deferred account gives the tax deferred investor such a head start that EVEN THOUGH HE PAYS MUCH MORE TOTAL TAX OVER HIS LIFETIME – HE STILL HAS MORE MONEY IN THE END!

Now there are plenty of reasons savers might want a sizable portion of their savings in after tax investment accounts – but when it comes to accumulation power the pre-tax account wins!

I will gladly share my spreadsheet analysis with anyone who is geeky enough to want to explore this in greater depth!

Take Care of Year End Housekeeping

Here is a short checklist of financial chores you want to make sure you complete before year end.

Harvest Your Losses: I prefer not to wait until the end of the year to do this, but if you have or expect to have capital gain income, take the time to browse your portfolio for positions that show a loss.  You can sell them, realize the loss for taxes, then either wait 31 days to buy the position again, or buy something else (as long as it is not a direct replacement) with the proceeds.  Capital losses can be used to offset any capital gains incurred in the current year, or you can apply $3000 per year in losses against your ordinary income and carry over the balance to next year.   (if Financial Pathways is minding your investments, we are already doing this for you…

Review Income Distribution Plans for Mutual Funds in Taxable Accounts. During the 2008 financial crisis, many mutual funds accrued substantial losses on their investments.  They used those losses to offset gains for the next several years – so investors have not seen much distribution of capital gains in the past several years.  Most of those losses have been used up by now – so be prepared to see some income distributions from your mutual funds.

Remember, most mutual funds will distribute gains and income near year end, and those gains will be distributed to the current owner – regardless of how long you have owned the fund, and regardless of whether the fund itself has gone up or down in value since you bought it.  It can be very annoying to buy a fund today and next month get a big taxable income distribution – when you did not even enjoy the appreciation of the fund.  It is like paying tax on somebody else’s gain!

To beat the system, you need to know when a tax distribution is coming.  Fortunately the fund companies make this information publically available. Go to the fund company website and look for estimated 2014 income distributions.  If the income distribution is substantial, you have a few choices:

1. See if you have any positions you can sell at a loss, and use the loss to offset any gains being distributed from the fund.

2. Decide whether it will be more advantageous to keep the fund and pay the tax, or sell the fund and pay any capital gain due on the sale of the fund. If you want to stay invested, simply replace the mutual fund making the distribution with a similar fund that does not have a large distribution scheduled.  Index funds and Exchange Traded Funds tend to be more tax efficient and make fewer taxable distributions.

 Having just been through this exercise with my client accounts I found a great new resource which makes this job far easier.  The free website gathers together gains distribution information from all major mutual fund companies and makes it easily available in one simple website.  Saves lots of time!

Take your Required Minimum Distribution. If you are age 70.5 or older, you must take taxable distributions each year from your IRA or other pre-tax retirement accounts.  Make sure you have taken your RMD’s before year end, or face potential severe tax penalties from the IRS.

Make Deductible Payments Before Year End: Make charitable contributions, tuition payments, student loan payments, medical payments, and any other payments which may be tax deductible before year end.

Make Tax Smart Charitable Donations. If you have highly appreciated securities in your account, think about giving them to your favorite charity instead of just writing a check.  You get the same deduction for giving $1000 in stock as you do for gifting $1000 in cash.  But if you purchased the stock 20 years ago for $250, you can avoid having to pay tax on the $750 capital gain.  This can be a great way to reduce holdings of a position which has grown to represent too large a share of your portfolio.

Plan for those deductible expenses which are subject to a % of AGI threshold. For example, you can only deduct medical payments to the extent they exceed 10% of your Adjusted Gross Income.  Well, if you are expecting a large medical expense in 2015, you may be better off waiting until next year to pay the bill that is already sitting on your desk.  This may permit you to combine with next year’s expenses to exceed the threshold.  The same goes with miscellaneous expenses (accountant and financial advisory fees, unreimbursed employee expenses, etc.) which are only deductible to the extent they exceed 2% of income.  You are better off shoving more of these expenses in a single year whenever possible.

Make your IRA Contribution for 2014. Even if you have a retirement plan at work, there are two ways you can still contribute to an IRA.  If you are eligible, you can contribute after tax money to a Roth IRA.  If your income is too high for a Roth, you can actually contribute after tax money to a traditional IRA.  You may choose to leave the money to grow tax deferred, or you may turn around and convert to a Roth through what is often termed a “back door conversion”. Be careful and consult with your financial or tax advisor, the rules are complicated!




December Markets and Economic Commentary

This month is all about oil!

November was a relatively stable month for investments, continuing a recovery trend which started in mid October.  December however, is shaping up to be a bit more  “interesting”.

Surely you have noticed that you aren’t dropping nearly as much at the gas pump lately.  The crude oil market is experiencing something that we have not seen since the early 1990’s – an oil supply glut.  Thanks to the new extraction technologies and vastly improved fuel efficiency, the world finally has more oil than it needs.  Far more in fact.

So isn’t cheaper oil good for the economy?  Well, yes to a point.  In fact, if you remember back to 2007, the soaring price of oil was one of the factors that led to the financial crisis.  The cost of fuel added to rising interest rates and resetting “exotic” mortgages was what led to the soaring mortgage default rates that nearly destroyed the financial industry.  So more money in people’s pockets thanks to lower gasoline and heating costs is a good thing.

But this may become too much of a good thing.  Oil is getting so cheap that many U.S. drillers may be put out of business.  We’re not talking Exxon or its ilk, but the smaller companies operating throughout the nation’s heartland.  What worries me is not what happens to the stock of oil companies (they have already been destroyed!).  Rather the danger  lies (just like the mortgage crisis) in debt.  Oil exploration has borrowed a huge amount of money in recent years – and those doing the borrowing may not be able to pay back their debts if they can’t make money on the oil they produce.

Debt default rates have been running near all time lows for quite a few years.  That stability has led many normally cautious bond investors to load up on these normally risky investments as they search for higher yielding investments.   But fear of rising defaults is already causing losses in the high yield bond and bank loan funds.  For a variety of technical reasons (mostly involving Dodd Frank regulations) if many investors try to exit their high yield bond or bank loan mutual funds or ETF’s at the same time, there could be serious liquidity problems in the bond markets. While we do not hold significant positions in either of those areas,  I am a little worried about potential spillover into the remainder of the markets.

Before we get too panicky over what might happen, it is important to keep in mind that the U.S. economy is doing fabulous.  Economic growth might top 4% for the second quarter in a row – which hasn’t occured since before the financial crisis.  As we noted, low oil prices will spur consumer spending.  Employment is growing steadily, and wages have finally started to rise in response to employer demand for workers.  The thing is – the stock market is already pricing all of this into its current prices, which are near all time highs (despite a significant sell off today).  So anything (such as a debt crisis springing from the oil industry) which threatens to upset the apple cart may cause stocks to fall back.

How long will the low oil be with us?  That is anyone’s guess.   Traders and speculators can impact the price day to day, but those moves are short term in nature.  Ultimately with any commodity product prices move in response to supply and demand.  Demand for oil  moves slowly.  Just as drivers didn’t run out and sell their SUV’s immediately when the price rose – drivers aren’t going to trade in their Prius to buy a Ford F250 just because the price of gas went down!  Therefore, it will take a decrease in supply to really move the markets.  In the past, OPEC would have jumped in and reduced production to try to support prices – but that doesn’t work anymore.  All they would be doing is enriching U.S. producers who would keep on drilling.

Just as with demand, oil supplies will be slow to respond.  Wells that are already drilled will continue to product oil, but ultimately low prices will force some producers out of the market.  Until that happens, oil inventories will pile up, and prices will be driven down.  Unless there is a major supply disruption (and it might take multiple simultaneous disruptions) the price of oil will be staying low for some time.

So plan a driving vacation, pump a little more carbon into the atmosphere, put a few extra gifts under the tree, and thank the genius engineers who brought us hydrofracturing technology.  You might even invite a petroleum engineer to your holiday dinner – because he may very well be collecting unemployment!


Stock Market Grows Uncertain.

Investment Markets Blowing Hot, then Cold, then Hot Again

Obviously last year was stellar for the stock market.  The S&P 500 was up over 30% in 2013.  It continued to move higher right through the first half of the summer.  Then things started getting dicey.

On Sept. 25th I commented in a blog post how the market was getting very fickle.  See “Bad News is Good News and Good News is Bad News”.   I posited at the time that this could be a sign that the market rally was running out of steam, and that I would not be surprised to see a market “correction”.  This is the term used when the market falls by 10% or more – usually for a short duration of time.

Now the problem with predictions like the one I made was that you cannot ever be certain what is going to happen with the markets.  Honestly I had been worried that the markets were overvalued for quite a long time.  It would be nice if you could say “the market is going to crash – lets sell everything and go to cash – or buy gold” – but it is never quite this easy.  What really happens to investment advisors who say this is they go to cash (hoping to protect their clients), the market goes up by 30%, and their clients fire them because they missed the rally.  You never really know what will happen next with certainty.

Now, I don’t want to toot my horn as far as predictions go, because a survey before the market fell indicated that 40% of investment advisors were expecting a correction before year end.  But within days after I wrote that blog post, the market turned very sour as news from around the world became scary and economies in Europe, China, and Japan all seemed to be stumbling.  Small company stocks were hit very hard, some measures falling 20%.  The S&P almost fell by the 10% that would have earned the term “correction” – but turned around just in time.

What I also pointed out in my comments on Sept 25 is that the U.S. economy appears strong for the time being.  I pointed out that it would be unusual to experience a severe and prolonged downturn in stocks while the economy continues to hum, although a temporary correction of 10% would be reasonable to expect given the huge runup stocks had experienced.

It now appears that the market “mini panic” may have indeed been short lived.   Markets are bouncing strongly back as companies report stronger earnings growth and some news out of China and Europe seemed more hopeful.  Doesn’t mean we are out of the woods, and markets have not regained all of their lost value, but 4 of the last 5 days realized market gains, and today is exceptionally strong for stocks.  So as I suggested in September, it appears that all the market needed was a good sound correction to make everyone stop and think for a minute.

Although it appears the market is optimistic once again, it would be prudent keep an eye on developments in Europe and China – I have been worried for years that these locations might be the source for the next financial shock.  The market was perhaps right to express concern.  For now though, stock investors seem to be hopeful that the increasingly impressive U.S. economic recovery will be just strong enough to pull the global economic train forward.


Financial Pathways Opens New Locations

Flanders and Cranbury Offices Open for Business

In an effort to make our brand of FEE ONLY fiduciary financial advice more widely available in western New Jersey, we have opted to consolidate our space in the Bridgewater Regus Center and open two new offices.  This is being done largely for the convenience of our current and prospective clients, some of whom were travelling considerable distances in New Jersey traffic to come visit us in Bridgewater.

The first location in Flanders is designed for the convenience of clients or potential clients in Morris, Warren and Sussex counties.  We chose this location when we realized that there is only one fee only advisor listed on the NAPFA website north and west of Morristown.  The office is about 5 minutes north of Chester and a similar distance south of Netcong at 230 Route 206, Flanders, NJ.

The second new site is what I will be calling my B&B location.  Our Cranbury office is located on the second floor in a historic building in downtown Cranbury New Jersey.  Cranbury is a charming and quaint historic business district located about 10 minutes south of Princeton, with sidewalk eateries, antique shops, and museums.  It is a very pleasant place to work.  I am looking forward to spending more time there.  The address is 50 North Main Street in Cranbury.

Luba and I intend to float between the offices based on client meeting requirements.  My wife Laura will be providing some additional part time administrative support as we continue to grow.

Financial Pathways in the News

Jim Kinney and Financial Pathways have been quoted in the news on several recent occasions.   Here are some recent articles which tapped our store of financial knowledge: 

In a July 23 Reuters article “Raid Your Kid’s College Savings?”

In a September 25 in a Yahoo News article on “Seven Financial Mistakes to Avoid in your 40’s

In an August 31 article in Financial Planning Magazine “New Rules for Reverse Mortgages”

In a article on “What to do if your parents wont pay for college”



When Bad News is Bad News, and Good News is Bad News

Market Commentary September 25, 2014

Bad News is Bad News and Good News is Bad News.

First of all, a very Happy New Year to all our Jewish friends and clients.   Wishing you much joy, happiness and prosperity.

It may be a sign that the current market bull is running out of steam, at least in the short term.

We had the market pull back (gently) on some weaker than expected economic news last week.  Today jobless claim numbers came out very strong indicating companies are simply not firing people.  This is good news for the economy – fewer firings mean more people making money.  More people making money means more revenues and more profits for American companies.

So how did the market react to this good economic news?  It is selling off strongly.  Why?  Because if the economy, and the job market in particular, is strong, then the Fed is prone to start raising interest rates.  And while (in small doses) that may not be bad news for the economy, it would be bad news for the stock and bond markets.  At least in the short term.

Now I wouldn’t make much of a scene over one day’s movements, especially since trading is very light today due to the Rosh Hashanah. (light trading tends to magnify movements in the market).  But still, this “bad news is bad, good news is bad” seems to be a recurring theme of late.   What might it mean? And how do you win in that kind of environment?

Frankly this is a very difficult time to make investment decisions.  On the one hand, markets seem very high after a long runup.  There hasn’t been a 10% correction since 2011, or a bear market (20% drop) since 2008/09.  This is very unusual, and many market analysts say we are overdue for a correction.  We also face risks of higher interest rates and geo political uncertainty upsetting the markets gravy train.  Bonds and fixed income no longer provide the same cushion as they used to, because the biggest risk to the markets right now is rising interest rates which can cause both stocks AND bonds to move in the same direction at the same time.

However, a search through market history makes it difficult to find a period in time when markets suffered SUSTAINED losses outside of a recession.  And what the market is essentially worrying itself over here is an economy that is TOO GOOD!  I think this is more of a TRADERS concern than an INVESTORS concern.  Yes, the market may react negatively to signs that interest rates may go up.  But I think a stronger economy, higher personal incomes, and resulting higher consumer spending ultimately trumps concerns about higher rates.

A short term pullback in excess of 10% is certainly possible and would not surprise me.  Interest rate trends bear watching.  I do not worry about a modest return to long term trends as much as a rapid series of hikes due to a return of inflationary pressure.  THAT could knock the wheels off the cart.  Assuming rates move gradualy and modestly higher, there is probably more risk to the bond market than to the stock market.

We have been doing what we can to address these risks as we see them.  Here are a few of the steps we take to manage risk in your portfolio:

  1. Knowing that bonds alone don’t provide the same protection for a portfolio in a rising rate environment, we have made increasing use of “hedged’ equity positions which rely on options or “short” postions to offset losses if the stock market falls.  These positions have admittedly been a drag on performance this year.  These strategies can do well in a market that moves decisively upward.  Some will do ok even in market that moves decisively downward!  But a market that just wobbles around without direction can cause these strategies to stumble.


  1. As early as late last year we reduced positions in utilities, MLP’s, and preferred stocks which are more sensitive to interest rates than most stocks. We did not eliminate all these positions – in particular our income oriented investors benefit from the high dividend yields, but we did cut back on recognition that these positions are prone to losses in an environment of higher interest rates.


  1. We have brought back a small allocation to gold which may do well if an accelerating economy results in increasing inflation (and higher rates). I am not a big fan of gold as an investment, but it is cheaper than it used to be, and in times of turmoil is often the only investment on the green side of the ledger.


  1. We have replaced some of our traditional bond allocation with non-traditional bond investments and international bond investments which strive to limit investment risk due to higher interest rates.


  1. We are replacing some fixed income investments in our income portfolios with inflation protected bonds. In the event recent employment trends persist and the economy continues to improve, inflationary pressures will likely begin to build.  Inflation protected bonds could gain if any rise in rates is accompanied by higher inflation.


  1. We are removing a bank loan ETF from our income portfolios due to underperformance in this sector, as well as my general concerns regarding liquidity and risk which has been increasing due to explosive growth in popularity of these investments.  Bank loans are popular due to the fact that interest rates are variable – making them somewhat less sensitive to rising rates.  At the same time however, their is substantial default risk in some of these loans, and if interest rates rise, defaults may increase.  The risk/reward profile of these investments is no longer very attractive.


We are fairly risk averse conservative investors.  Even our more aggressive growth portfolios are managed with one eye toward avoiding large losses.  But investors should be aware that even a conservative allocation to the stock and bond markets is subject to losses from time to time.  This is especially true in those unique environments when stocks and bonds both react strongly in a negative direction at the same time.  There is no magical investment allocation I can conjure up to avoid losses in every market environment.  The best strategy when things get dicey is to sit tight, think long term, and wait for conditions to improve.


Financial Pathways Opens Morris County Office

Increasing Demand for Fee Only Financial Advice Drives Firm’s Expansion

Flanders, NJ—Financial Pathways, an independent fee only financial planning firm headquartered in Bridgewater, NJ will be opening a new office in western Morris County to address a growing need for client-centered financial planning services.

James Kinney the founder of Financial Pathways. He explains the firm’s rationale for opening a branch office in western Morris county:  “We have noticed that several of our new clients were driving all the way down to our Bridgewater office from Morris County because they were having trouble finding the kind of unbiased planning advice that Financial Pathways is known for.  We are opening this new office to make fee-only financial planning services more readily available to residents of western Morris, Warren, and Sussex counties.”

Kinney has recently been admitted to the National Association of Personal Financial Advisors (NAPFA), a select organization of fee-only financial advisors with rigorous membership requirements and standards. NAPFA members only receive compensation directly from clients, thus eliminating conflict of interest that can arise when advisors are selling commission products. Financial Pathways is one of only two NAPFA registered fee only financial advisors in western Morris County, according to the NAPFA website.

Increasingly, potential clients are specifically seeking out fee only advisors, according to Kinney, resulting in growth opportunities for his firm. “People need to make these really important decisions regarding retirement, insurance, paying for college, or managing their investments.  When they turn to a professional advisor for help, they want to know that the advice they are getting is designed to help them realize their goals, rather than to maximize the advisor’s profit margins.  Working with a fee only advisor gives them peace of mind knowing their advisor has no hidden agendas.”

Financial Pathways new office will be located at 230 US Highway 206 in Flanders, and will be opening the week of September 15. For more information, call Financial Pathways at (973) 229-0801 or visit


Investment Returns over the Long Term – Lower Your Expectations

Clients often ask why we use such low expected returns in our financial plans.  We typically assume returns of 4 or 5% while long term average historical returns on both stocks and bonds are considerably higher than this.  Are we just being overly conservative?  Are we assuming “worst case scenario”?  

Sadly, I suspect we are simply being realistic.  The economy, and investment assets in general, will be facing headwinds over the next 30 years which we have not experienced in generations.  One is demographics, the other is interest rates and debt.  

The baby boom generation has seen a nearly continuous slide in interest rates since the early 1980s.  Those lower rates (aka cheap money) have fueled almost unprecedented growth in spending power of both governments and individuals.  They have also caused investment prices to skyrocket as cheap money flooded into stocks, real estate, and other investment assets seeking higher returns.  

Cheap money has become like crack to the economy.  The more we get, the more we need it.  Our cul de sac lifestyles are built on cheap debt.  Our government social programs are built on low interest rates.  

But rates have fallen to rock bottom.  We can’t go much lower.  While we may be able to enjoy these rock bottom rates a while longer, pressures will likely be building which inevitably will push rates higher.  And like any addiction withdrawal of the drug will cause pain.  

If interest rates on 10 year government debt rise from current 2% to 4% (and remember 4% seemed low only a few years ago!) interest expense (the largest item in the federal budget) will double.  Future government spending will be constrained.  This wouldn’t happen overnight, but stupidly our government has not locked in today‘s low rates by issuing long term debt, so the impacts of even a modest rate increase will be felt rather quickly in the federal budget.  This fiscal drag will be a substantial headwind for the economy.  

Meanwhile, on the household side with incomes barely growing, a rise in mortgage and consumer borrowing costs would dramatically reduce the affordability of big ticket purchases such as cars and more importantly to the economy, houses.  And in the world of investing, the end of cheap money means corporations won’t be borrowing money to buy back stock, one of the pillars of our current bull market in equities.   

When will interest rates move higher and how fast?  No one knows.  And I am by no means anticipating or predicting a market collapse.  I will leave that to those trying to sell books.  The current low interest low inflation environment that is so friendly to stock investors could continue for quite some time. A best case scenario is a slowly strengthening economy with a modest increase in rates and low inflation over a long period of time.  A worst case scenario might be a rapidly expanding economy unleashes inflationary forces which push interest rates rapidly higher.  That would almost certainly cause a subsequent market crash and recession.  There is room to consider the arguments of both optimists and pessimists.  

Looking forward over the next decade or two however, I would be surprised if interest rates do not become a drag on both the economy and investment performance.   Even in a best case scenario, rates cannot continue the downward march which has fueled investment growth over the past decades.  This is why we set lower return expectations than many of our planning peers.  Are we unduly pessimistic?  Maybe. But there is no harm in planning for the worst and hoping for the best.  

Mutual Fund Fees Explained

The low-down on mutual fund fees

One of my newer clients was reading her fund prospectuses (prospecti???) recently and asked me to explain how the various fees work.  After getting over my initial surprise that someone actually reads the fund prospectus (just kidding, I know you all do!), I figured that this was a topic that might be of interest to some other people out there.  After all, there is a lot of talk in the financial media about mutual fund fees – but I also find many people misunderstand how they work.  Fund expenses are complicated stuff, and although I will try to explain in simple terms, please forgive me if I cause your eyes to glaze over.

Management Fees.  These fees pay the manager of the fund (Vanguard, Pimco, etc.) to do their job.  The fund manager selects the investments that go into the fund.  Theoretically, the more the manager is doing (the more ACTIVE he is), the higher the fees are going to be.  An index fund typically has the lowest fees, because the fund’s investments are already selected for it.  All the manager has to do is buy and sell shares of stocks to mimic the holdings that comprise the index which the fund tracks.  This can largely be done by computer, so costs and fees are minimal.  A fund manager who researches and selects stocks will have higher costs to pay for his analysts and research tools.  And researching small companies, or overseas companies, or specialty market segments tends to be more difficult and expensive than researching large well known companies.

It is important to realize that management fees are paid for by the fund itself – not by the investor.  So if a fund advertises a return of 8%, that implies that the fund earned 8% after all its internal operating expenses were met.  While it may be surmised that if the same fund didn’t have its 1% in management fees it WOULD HAVE earned 9% – this is a somewhat flawed logic, since without the expenses that fund would not have existed in the first place.  See below for further discussion of the impact of fees on investor returns.

Sales Charges (aka “loads”).  These are fees which go directly to compensate the broker who sells the fund.  They are essentially a sales commission paid by YOU the investor.  Front end loads (typically identified as Class A) are paid for up front by the investor.  If you buy a fund with a 5% front end sales charge (load) for $1000, then $50 is taken out of your investment to pay the selling broker, leaving you with a $950 investment.  Level load funds (typically identified as class C) have fees usually of about 1% per year deducted from the investors account to pay the broker.  Over many years level load is more expensive – but since you paid less up front it is easier to sell the fund without any loss.

Most fee only or fee only investment advisors (as opposed to commissioned advisors) do not accept commissions on mutual fund shares, which means these sales charges will normally be “waived”.  If you are paying your advisor a fee for his services, make sure you are not also paying a commission.  That would be double dipping, and would not be appropriate in most cases.

12b-1 fees.  OK this may be the least understood (and least discussed outside the industry) of all mutual fund fees.  Many funds have a small annual fee called a 12b-1 fee listed on their prospectus.  This is a fee that is remitted to the brokerage firm that hold the shares and is supposed to pay for paperwork, marketing services, etc.  It is often used by commission brokers to pay an additional annual commission to the salesman.  However, these fees may also be used by custodians (such as TD Ameritrade) to offset the costs of including a fund in a No Transaction Fee trading platform.  In this case, the additional fund cost (typically about .25%) may be more than offset by the fact that an investor does not have to pay a trading cost or commission every time he buys, sells, or rebalances his portfolio.

Trading Costs.   The direct cost to the fund of executing transactions (buying and selling stocks or bonds) is not included in either of the above.  And it is almost impossible to determine what the trading costs of a fund are.  They are not listed in the prospectus.  As with management expenses, these are costs paid for by the fund before quoting any returns to investors – so these are not expenses you pay directly.  However, it is sensible to surmise that the more a fund manager trades in and out of stocks, the higher his trading costs.  Those who don’t mind reading a fund prospectus can look to the Turnover rate to estimate how often a manager trades.  A fund with a 10% turnover rate sells about 10% of his holdings in a given year.  This would be pretty low, and suggests the manager holds onto an investment for an average of 10 years.  A fund with a 100% turnover rate would on average sell every holding (and replace it with a new one) every year.  This would be a very high turnover ratio.

Tax Costs.  Don’t ignore the tax implications of a fund you own.  The more a fund buys and sells shares, the more likely you will be to see taxable capital gain distributions at the end of the year.  You will receive a 1099 and pay tax on these distributions.  Index funds tend to have fewer capital gain distributions – but not necessarily so!  High turnover funds are more likely to spin off taxable gains than low turnover funds.  And of course, you don’t have to worry about tax implications if your fund is owned in an IRA or 401k.

So is the lowest cost fund always the best choice?  Many in the media seem to take this simplistic approach, but it is not necessarily so.  It is true that most managers of your typical domestic stock funds fail to do any better than a similar index fund.  This is often attributed to the fact that the investments the fund holds needs to beat the index by the amount of the fee just to result in a tie!  Few managers seem to be able to generate these results solely by “picking” large cap US stocks.  So for exposure to these stocks, an index tracking mutual fund or ETF might be the best approach.  However, in more nuanced and complicated segments of the market (international, emerging markets, fixed income, alternative strategies) a good manager may be worth his keep even after considering fees.  This does not necessarily mean he will generate outsize returns.  In fact, a manager can just as well add value by avoiding trouble spots and reducing risk and volatility.  To support this premise, studies have shown that  active managers historically have enjoyed their best years (vis a vis their benchmark index funds) when markets are losing money.

Fund expenses are important – but they should not be the only consideration when choosing an investment to add to your portfolio.