What Is a 12b-1 Fee in a Mutual Fund?

If your investment portfolio includes mutual funds, you may continue to enjoy returns for years to come. But the growth of your funds may also come at the expense of annual fees that can chip away at your profits. A closer look at your mutual fund's prospectus may reveal that you’re even paying fees for the marketing and promoting of your fund – fees that are known as 12b-1 fees.

Origin of 12b-1 Name

The utilitarian name for the 12b-1 fee simply refers to the same-numbered section of the Investment Company Act of 1940, titled “Functions and Activities of Investment Companies.” Enacted by Congress, and enforced and regulated by the Securities and Exchange Commission (SEC), this legislation establishes standards for investment companies by regulating their organization and defining their responsibilities and activities.

What's a 12b-1 Fee?

A 12b-1 fee is an annual fee on a mutual fund that represents marketing or distribution costs for the operation of a fund. Because 12b-1 fees are part of operational expenses, they are included in the expense ratio of a fund and expressed as percentages.

Reason for 12b-1 Fees

Originally established to help investors, 12b-1 fees gradually shifted as an incentive for intermediaries to sell shares of certain funds. When mutual funds were a fairly new investment option, the prevailing thought was that a fund’s participation would increase by promoting the fund through marketing and advertising strategies. To pay for these marketing expenses, 12b-1 fees were allowed by the SEC to be deducted from an investor’s mutual fund and used to pay commissions to brokers for their sales and marketing efforts to promote the fund.

How Much Are 12b-1 Fees?

A 12b-1 fee represents different components of the fund's costs, but the total fee carries a 1 percent cap of the investor's balance. Although 12b-1 fees are actually deducted each day from an investor's account, it's the total annual fee that cannot exceed the 1 percent cap.

Components of 12b-1 Fees

The 1 percent annual cap for 12b-1 fees represents a combination of two fees, each of which has its own cap:

• The distribution and marketing fee has an annual cap of 0.75 percent
• The service fee has an annual cap of 0.25 percent

The SEC allows a mutual fund to pay distribution and marketing fees only if the fund is set up as a 12b-1 plan to authorize these fees, but a mutual fund is allowed to pay service fees regardless of whether it’s set up as a 12b-1 plan.

12b-1 Distribution and Marketing Fees

This component of the total 12b-1 fee pays for advertising and marketing costs as well as broker commissions and compensation for other professionals who sell fund shares. The “distribution” part of this fee refers to the costs of preparing, printing and mailing prospectuses as well as mailing other literature about the fund to clients as well as potential new investors.

Although the SEC doesn’t place a maximum on all these costs for the fund, it does cap the cost that’s passed on to investors at 0.75 percent.

12b-1 Service Fees

The service fees portion of the total 12-b1 fees goes to pay for the fund manager for hiring and paying service providers. These providers answer investor questions about the fund, provide customer service and send fund information to investors.

Although a fund is not required to be set up as a 12b-1 plan to assess this fee, the fee must be identified as a shareholder’s service fee in the fund’s fee table. If the fund is not set up as a 12b-1 plan, the service fee must be included in the category of “other expenses.” Regardless of whether a mutual fund is set up as a 12b-1 plan or not, the service fee is limited to a maximum of 0.25 percent.

Mutual Funds With 12b-1 Fees

There are three primary classes of mutual fund shares – Class A, Class B and Class C. Because Class A investors pay fees up front, such as sales and marketing commissions, they typically pay only the 12b-1 service fee. But Class B and Class C investors typically pay the 12b-1 distribution and marketing fee as well as the service fee. The back-end fees that characterize Class B shares decrease over time, but Class C shares generally have the maximum 1 percent 12b-1 fee.

Investors should know that even no-load mutual funds may carry a 0.25 percent service fee. Although 12b-1 "fees" and "no load" may sound like contradictory terms, both terms may apply to the same mutual fund.

Mutual Funds Without 12b-1 Fees

While approximately 70 percent of mutual funds charge at least a portion of 12b-1 fees, the remaining 30 percent of mutual funds are free of these fees. Some fund managers take a fiduciary stance toward their investors by not charging 12b-1 fees, because they simply view the fees as unnecessary.

After reviewing a fund’s prospectus, an investor may decide that paying 12b-1 fees could result in a greater return on the investment than not paying the fees. On the flip side, however, an investor may determine that paying 12b-1 fees is simply not justified for the rate of return. By performing some due diligence as you research your risk versus your reward, you’ll be better able to make an educated investment decision.

Fund Examples Without 12b-1 Fees

If you want to manage your own mutual fund investments and cut out the fund managers, you can open an online account on a website such as Vanguard or Fidelity to build your own portfolio. This way, you’ll be able to optimize your expense ratio.

Exchange-traded funds (ETFs) and passively managed mutual funds are other investment options with low expense ratios. For example, at the time of publication, Fidelity offers a 0.084 percent expense ratio for sector ETF funds.

Broad-market index funds are another low-cost option, with fees that typically are less than 0.25 percent.

How 12b-1 Fees Affect Investments

Although 1 percent may sound like a nominal fee to pay for marketing, advertising and providing customer service for your mutual fund, this potentially represents a substantial chunk of change over time. For example, you may forfeit $2,264 in profit if you invest $10,000 for 10 years in a mutual fund that pays a 10 percent return and carries a 1 percent 12b-1 fee. Doing the math, your balance at the end of 10 years totals $25,937, minus 12b-1 fees of $2,264, for a net total of $23,673.

But if you invest that same $10,000 for 30 years, you’ll forfeit a whopping $41,822 in profit using the same interest rate as the above example. At the end of 30 years, your balance totals $174,494, minus 12b-1 fees of $41,822, for a net total of $132,672.

Find 12b-1 Fees in Prospectus

When you’re researching mutual funds as potential investments, you may want to look for funds that have the lowest expense ratios. Some mutual funds list the fund’s total expense ratio, but you’ll have to dig a little deeper to find a breakdown of each fee in this ratio, including the 12b-1 fee. You can find this breakdown in a fund’s prospectus, which is required to list specific fees.

The list of fees in a prospectus includes management fees, front-end sales loads, back-end fees, account administration fees, networking fees and recordkeeping fees. Among the menu of fees in the shareholder fees section, you’ll find 12b-1 fees, listed as marketing and distribution fees as well as shareholder service fees.