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How to guard your bottom line

May 22, 2013

You get what you pay for, right?

Actually, when it comes to investing, it's what you don't pay for that really counts.

Keeping investment costs and taxes low is crucial to reaching your financial goals. Every dollar you pay toward your investment company's overhead—or to the tax collector—is a dollar that disappears from your net returns.

High investment costs can mean less money compounding for you over time and less income in retirement. By keeping an eye on costs and taxes, you can help put yourself on the path to becoming a successful investor.

INTERACTIVE TOOL

See how costs can erode your returns

Use our interactive illustration to see how even small changes in an investment's expense ratio can have a big impact on your long-term performance.

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Watch your bottom line

While you can't control what happens on Wall Street, you can control how much you pay to invest.

Every mutual fund has an expense ratio—the percentage of the fund's total assets deducted from its returns each year to cover administrative expenses. For some, it's as high as 2.0%, meaning you'd pay $200 annually for every $10,000 you've invested. And many funds tack on additional costs, such as sales charges, trading fees, commissions, and so on.

Those expenses add up, and they can create a major drag on net investment performance. In fact, when the Financial Research Corporation, an independent consulting firm, looked at ten different characteristics of mutual funds, it found expense ratios to be the only factor reliably linked to net performance.

Here's an example. Let's say you have $200,000 to invest, and you decide to split it evenly between two mutual funds that are identical in every respect except one: "Fund A" has an expense ratio of 0.23%, and "Fund B" has an expense ratio of 1.19%. Assuming a 6% annual rate of return for both funds, after 30 years, Fund A would net you an "extra" $134,959—all because of that seemingly minor difference in expense ratios. That's why it pays to shop around before you invest.

Fund costs count
This hypothetical illustration does not represent any particular investment, nor does it account for inflation. There may be other material differences between investment products that must be considered prior to investing. All investments are subject to risk.

It's easy to overlook investment costs, especially when investment companies spend millions of dollars on advertising campaigns that tout strong performance. What they often don't tell you is that those attractive short-term returns are sabotaged by hefty expense ratios.

Fortunately, it's easy to uncover a mutual fund's expense ratio—you'll generally find it on your investment provider's website.

Don't forget about taxes

While we're on the topic of costs, let's not overlook what may be the biggest expense of all: taxes.

As a mutual fund investor, you're subject to two types of taxes. When a fund distributes long-term capital gains or when you sell shares at a profit, you're taxed at capital gains tax rates (15% for most investors). When a fund issues dividends, you're taxed at your ordinary income tax rate, which can go as high as 39.6%.

One way to maximize your after-tax returns is to consider investing in tax-efficient mutual funds such as low-cost index funds or tax-managed funds. To postpone paying taxes, at least for a while, you can put money in tax-deferred accounts, such as 401(k)s or IRAs. Generally speaking, it can be a good idea to put income-generating investments, such as taxable bond funds, in these accounts.

Bear in mind that if you trade investments frequently, you may forfeit virtually all of the tax-efficiency they offer.


NOTE:

  • All investing is subject to risk, including possible loss of principal.
  • When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
  • Consider consulting a tax advisor about your individual situation.
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