Hidden Fees in Investing

Investing fees are not always easy to spot. Mainly because Wall Street has done a good job burying these fees in the small print of hundreds of pages of the prospectus. If they fully disclosed their compensation, investors would balk. Therefore, this post will explain some hidden fees that investors don’t always see, including transaction fees (commissions), internal expense ratios, trading costs, and, believe it or not, taxes.

Transaction Fees

Transaction fees are different depending on where you place the transaction. A typical full-service broker will charge you a commission to buy or sell an investment. These commissions cost you from 4.5% to 5.75% upon initial purchase, or 7.5%, in the form of a surrender fee. Surrender fees usually diminish by 1% each year the investment is held, giving you the incentive to hold the investment for 7 years. Annuity commissions can cost from 7.5% to 15% upon purchase of the annuity. As a result of massive commissions, discount brokerage firms like Schwab, TD Ameritrade, and Fidelity have flourished. They charge between $0 and $30 a transaction.

Internal Expense Ratios

Internal Expense Ratios range from 0.03% to 2.5% and up. Years ago, an investigation into 403b plans discovered internal expenses greater than 5%. As a result, the 403b market is now more closely monitored. Your typical fee-based advisor will allocate in mutual funds with expense ratios of 1% or higher.

Trading Costs

Trading Costs are costs that mutual funds and separately managed account managers pay in the form of brokerage transaction fees. You pay these fees from interest or capital gains within the fund. It is almost impossible to get detailed information about the costs of these transactions. An article in the Journal of Finance (August 2000) found that the average aggregate mutual fund costs were 0.8% a year. This cost is from active managers employing stock picking in their investment style, causing high turnover. Index funds had an average transactional cost of 0.07% over the same period. Therefore, the extra 0.75% goes into your pocket using index funds.

Taxes

Taxes reduce the realized return of an investment outside a qualified or retirement account. Most investors look at pre-tax returns with little regard to the after-tax tax return. Because of this, gross returns are lost to the IRS. However, an Alliance-Berstein study of 1201 U.S. large-cap stock funds from 1998 to 2003 found that the average shareholder had an average annualized return of 10.0% pre-tax and 7.7% after federal taxation of dividends and capital gains.

Equally as important to investing in tax-efficient funds is when you invest in these funds. An advisor buying before a large capital gain may encounter more tax than they expect, as is the case in this July 1999 Money magazine article entitled Mutual Fund Tax Bombs:

On Nov. 11, 1998, a physician in San Francisco invested $50,000 in a mutual fund called BT Investment Pacific Basin Equity. In January, scarcely seven weeks after he had bought the BT fund “ he got the shock of his investing life. On his original $50,000 investment, BT Pacific Basin had paid out $22,211.84 in taxable capital gains. Every penny of the payout was a short-term gain, taxable at the doctor’s ordinary income tax rate of 39.6%. He suddenly owed nearly $9.000 in federal taxes. As a California resident, he was also in the hole for $1,000 in state tax.

The above example was taken from The Bogleheads’ Guide to Investing. This is an excellent read to learn about investing.

You can also use tax-managed strategies to minimize federal taxes on capital gains and dividends, along with tax loss harvesting strategies to further reduce the amount of taxes paid. For more on how you can benefit from tax deferral, look for my post on Advanced Tax Deferral.

Originally posted July 11th, 2011. Updated August 11th for accuracy.