What is this 12b-1 fee in my 401(k)?

LAST REVIEWED Nov 29 2018 10 MIN READ

By Anisha Sekar

If you haven’t heard of a 12b-1 fee and just discovered it in your 401(k) charges, you’re not alone. This charge, which earns mutual funds $10 billion a year, is often tucked away into a fund’s prospectus. 12b-1 fees are often used to cover marketing materials and commissions to brokers who peddle the fund. In theory, 12b-1 expenditures can actually make a fund more attractive through economies of scale: more marketing means more investors, and more investors means less overhead per person. But in practice, 12b-1 fees can inflate the cost of a mutual fund with little return.

So what does a 12b-1 fee do, anyway? Do higher 12b-1 fees indicate better performance, or the reverse? And what’s a reasonable charge? We’ll break down 12b-1s and help you decide if you’re investing in the right funds.

What is a 12b-1?

12b-1 fees are broken down into two charges: marketing and distribution, and service. Marketing and distribution fees are often commissions paid to investment intermediaries (like financial planners, advisors, and brokers) and are capped at 75 basis points (0.75% of assets). Service fees, also called trailing commissions, are paid to brokers for providing investment advice, customer service and other ongoing support for customers, and are limited to 25 basis points (0.25%). Between the two, 12b-1 fees are limited to 1% of assets, but they’re typically charged as a flat rate rather than a percentage.

12b-1 fees were legislated into existence in 1980, under the premise that allowing mutual funds to advertise would increase their customer base and allow for economies of scale. However, in the nearly eighty years of its existence, opinion on the 12b-1 has soured. Investment analysts say that not only do 12b-1’s fail to improve performance, they also create a conflict of interest: Fund managers earn their paychecks based on assets under management, so they’re incentivized to try to bring in new investors through marketing rather than a solid track record. As a result, many financial advisors recommend steering clear of mutual funds with 12b-1 fees.

Where exactly can I find my 12b-1 fee?

If you look at a mutual fund’s quick facts, you’ll typically see its performance, load, total assets, and overall expense ratio. The 12b-1 fee is an operational expense, and is therefore included in the expense ratio, but you’ll have to do a little more digging to isolate that specific charge.

Instead, you’ll have to look at the mutual fund’s prospectus under the shareholder fees section to see how much it’s charging for marketing and distribution or account service. You can find prospectuses (also known as 485 filings) on the Securities and Exchange Commission’s website; through brokers like Vanguard, Charles Schwab, or Fidelity; and on Morningstar’s fund overviews – they often break 12b-1 fees out of the overall operational expenses. Prospectuses are available to read whether or not you’ve bought shares in the fund.

Finally, keep in mind that no-load funds, which don’t charge commissions when you buy or sell shares, can still charge 12b-1 fees (we’ll go into this more in the next section).

Front-end, back-end, and 12b-1

When you’re choosing a mutual fund, you’ll want to watch out for loads – commissions or sales charges that investors pay to the fund. 12b-1 fees are a type of load themselves (in fact, they’re sometimes called level loads), and as annual charges are included  in a fund’s operational expenses.

There are two other load types to keep an eye on: front-end and back-end loads. Front-end loads are a one-time purchase fee paid when you first invest in a mutual fund, and are deducted from the investment amount. For example, if you invest $10,000 in a mutual fund with a 4% front-end load, the fund will keep $400 and your initial investment will be just $9,600. Typically, front-end loads range from 3.75-5.75%.

Back-end loads, as you might have guessed, are sales commissions applied when you redeem shares in the mutual fund. They’re often used as an incentive to keep investors’ assets for a set period of time, so back-end fees often decrease over time and can be waived entirely after the fund’s holding period ends. Back-end fees are charged as a percentage of the shares you redeem, so if a fund’s back-end fee is 3% and you redeem $10,000 worth of shares, you’ll only get $9,700 of that money.

Neither front-end nor back-end loads are included in a fund’s operating expenses, since they’re one-time charges rather than ongoing levies. Just to make things more confusing, funds that list themselves as “no-commission” can’t charge front- or back-end loads, but they can charge a 12b-1. You’ll need to watch out for all types of sales commissions when evaluating funds. However, some mutual funds waive front-end, back-end, or 12b-1 fees for investors purchasing through their employer-sponsored retirement program.

Is my 12b-1 fee reasonable?

While 12b-1 fees haven’t been shown to increase a fund’s performance, they are not uncommon among mutual funds. A 2010 Motley Fool analysis of 3,796 Morningstar funds found that just over 40% levied 12b-1 fees, with an average fee of 0.31% and average overall expense ratio of 1.45%. But here’s the key: funds that charged 12b-1 fees had an average 15-year annualized performance of 6.96%, while funds that didn’t charge 12b-1’s had a lower expense ratio of 1% and had a higher 15-year performance at 7.49.% So not only do 12b-1 fees charge more fees overall, but they fail to deliver better performance.

If you ask many financial advisors what a reasonable 12b-1 fee is, most of them will recommend avoiding them altogether. While it’s impossible to make hard-and-fast rules, typically, lower fund fees translate to higher investor returns. This is especially true with long-term investment accounts like 401(k)’s, when small fees can eat away at your returns over time.

How to minimize funds’ overhead

So how do you choose a fund that delivers low fees without sacrificing performance? First, you may want to consider an exchange-traded fund (ETF) or passively managed mutual fund rather than an actively managed mutual fund. ETF’s don’t require decision-making from fund managers – they simply track all the stocks in a particular index, like the Russell 2000 or S&P 500. Passively managed mutual funds also track indices, but they’re regulated as mutual funds rather than ETFs (more on the difference between mutual funds and ETF’s). Both types of funds have very low expense ratios, since there’s minimal overhead required. With actively managed mutual funds, on the other hand, fund advisors select individual stocks to invest in. Since you’re (theoretically) benefiting from the advisors’ time and expertise, active mutual funds have much higher fees. In 2014, passive funds (both ETF and mutual) had an average expense ratio of 0.2%, compared to 0.79% for active funds.

Choosing a passive fund will minimize your overall expense ratio, which benefits your long-term gains. However, you may choose to avoid 12b-1 fees specifically on philosophical grounds, because they’re increasingly associated with conflicts of interest and a lack of transparency.

Here at Human Interest, we’re committed to making 401(k)’s affordable and transparent, so we’re focused on funds with minimal expense ratios. We choose the lowest-fee funds in each asset class, and also consider hidden costs like trading activity, which drives up transaction costs. Learn more about our investment philosophy or sign up for an affordable 401(k) today.

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Anisha Sekar has written for U.S. News and Marketwatch, and her work has been cited in Time, Marketplace, CNN and more. A personal finance enthusiast, she led NerdWallet's credit and debit card business, and currently writes about everything from getting out of debt to choosing the best health insurance plan.

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