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My coworker told me that he pays his index fund expense ratios with cash instead of having the brokerage take it out of the fund balance.

So to give an example. Say I have $20,000 in the Fidelity Total Market Index Fund FSTVX with an expense ratio of 0.045%/year. That means 0.045% of the balance is taken out every year by Fidelity as expenses, so that would be $9 here.

I think what my coworker meant is that he pays this $9 with cash, rather than out of the fund balance of $20,000. That way you are not depleting fund balance.

What are the costs and benefits of this approach vs. paying expense ratios out of the fund balance as normal/default?

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In many cases the expenses are not pulled out on a specific day, so this wouldn't work.

On the other hand some funds do charge an annual or quarterly fee if your investment in the fund is larger than the minimum but lower than a "small balance" value. Many funds will reduce or eliminate this fee if you signup for electronic forms or other electronic services. Some will also eliminate the fee if the total investment in all your funds is above a certain level.

For retirement funds what you suggest could be made more complex because of annual limits. Though if you were below the limits you could decide to add the extra funds to cover those expenses as the end of the year approached.

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It seems at most a cosmetic difference - nothing keeps you from adding the 9$ cash to the fund the same day the fees are deducted from the shares.

  • The fees for the expense ratio are deducted on a daily basis and show up as a. very small reduction of the reported NAV. So this strategy does not work in most cases. Where it would work is for the annual fee or quarterly low balance fees as mentioned in mhoran_psprep's answer. – Dilip Sarwate Jul 22 '17 at 12:42
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Simply put, that's not allowed.

Outside a retirement fund, they simply do not provide a mechanism to pay that expense ratio separately. Ergo, any effort to pay that expense ratio would be classified as a new/additional purchase of the fund. You now must deal with

  • any fund rules about activity or minimum purchase size
  • creating a separate purchase with a separate cost basis, complicating tax paperwork.

Inside a retirement fund, paying the expense ratio of the fund with cash would be treated as an additional contribution, which may then violate contribution rules (such as going over your contribution limit, or contributing past age 70-1/2).

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    Yeah I think my coworker was talking about retirement accounts. I would think if you contribute that extra $9 or whatever amount, it would put you over the limit, if you were already at the limit. – TangoFoxtrot Jul 23 '17 at 18:32
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The mutual fund is legally its own company that you're investing in, with its own expenses. Mutual fund expense ratios are a calculated value, not a promise that you'll pay a certain percentage on a particular day. That is to say, at the end of their fiscal year, a fund will total up how much it spent on administration and divide it by the total assets under management to calculate what the expense ratio is for that year, and publish it in the annual report. But you can't just "pay the fee" for any given year.

In a "regular" account, you certainly could look at what expenses were paid for each fund by multiplying the expense ratio by your investment, and use it in some way to figure out how much additional you want to contribute to "make it whole" again. But it makes about as much sense as trying to pay the commission for buying a single stock out of one checking account while paying for the share price out of another. It may help you in some sort of mental accounting of expenses, but since it's all your money, and the expenses are all part of what you're paying to be able to invest, it's not really doing much good since money is fungible.

In a retirement account with contribution limits, it still doesn't really make sense, since any contribution from outside funds to try to pay for expense ratios would be counted as contributions like any other. Again, I guess it could somehow help you account for how much money you wanted to contribute in a year, but I'm not really sure it would help you much.

Some funds or brokerages do have non-expense-ratio-based fees, and in some cases you can pay for those from outside the account. And there are a couple cases where for a retirement account this lets you keep your contributions invested while paying for fees from outside funds. This may be the kind of thing that your coworker was referring to, though it's hard to tell exactly from your description. Usually it's best just to have investments with as low fees as possible regardless, since they're one of the biggest drags on returns, and I'd be very wary of any brokerage-based fees when there are very cheap and free mutual fund brokerages out there.

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