May be it is something already discussed a few times, but still...

If I want to sell my mutual funds (after holding them for 2 years), is there any way to avoid paying penalty? It's somewhat around 5% of my holdings which is going to totally destroy all my earnings.

Backend loads typically decrease the longer you hold a fund. Check the prospectus.

That I know. The ones I'm holding in my portfolio start at 6.5% (I believe) and goes down to zero in seven years. I'm two years into investment and want out, but how can I do that without paying the penalty?

You can't get out without paying the penalty. I tried looking for a loophole with mine, but no dice. HOWEVER, many funds will let you move 10% of your holdings (as of Dec 31 of previous year) out every year. You could do that annually until the fee falls to a more reasonable level. Note that if you are currently paying an MER of 2 or 3% and you move to a fund or ETF that has a much, much lower MER, the 5% isn't quite as high as it seems.

It sounds like you were sold class B shares. They are nicknamed "Broker Shares" because that's who really makes out on the deal. Whomever sold those funds to you got a large, up front pay out and also earns a trailing commission every year for as long as you own it. That is the reason for the back end load, to recoup the commission paid. B shares also draw the most regulatory attention and complaints.

There are generally four courses of action you could look at:

1. Wait it out.

2. If the broker didn't offer you other share class options or follow his firm's procedures for running a share class expense analysis, you may have grounds to make complaint to the broker's management, or the NASD. By writing to the broker's manager or compliance department (NASD regulations cause written complaints to be taken more seriously than verbal ones) you may get the brokerage to credit something to your account.

3. You can usually exchange the funds for other funds in the same fund family of the same share class without penalty if they have other funds you like better. Also, there are some funds that may have different back end loads within the same family of funds. You may be able to exchange to a load on exit, then sell it and pay less. You'd need to look at the other offerings of the same share class at the same fund company.

4. Consider just selling them and paying the 5%. B share mutual funds are among the most expensive investments to hold even if you hold it for 7 years. They usually have high management expenses plus 12b-1 fees upwards of 1%. If you sell now, eat the 5%, and buy a similar no-load fund without a 12b-1 fee you could be saving 1% (maybe even more on other expenses to) each year, compounded, over the next 5 years. Those high expenses are and will continue to destroy your earnings anyway.

You can look at this as the opportunity cost associated with keeping your current investment. You have money that could theoretically be used for higher returns.