Choosing Between Roth IRA and Mutual Funds

You Don't Have to Choose Between a Roth IRA and a Mutual Fund

Older woman contemplating financial statements
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A common question asked by new investors is whether they should invest in a Roth IRA or a mutual fund. This question can't really be directly answered, because It's comparing an apple to an orange. There are several differences between a Roth IRA and a mutual fund, such as the fact that unlike a mutual fund, a Roth IRA is not a type of investment. A Roth IRA is a type of account. You can hold investments such as stocksbonds, cash, and, yes, even mutual fundswithin a Roth IRA.

Different types of institutions offer their own versions of a Roth IRA. A Roth IRA from a discount broker such as Charles Schwab lets you buy practically any type of investment, including stocks, bonds, and mutual funds. A Roth IRA from a bank will probably only let you buy certificates of deposit or money market securities. A Roth IRA from a mutual fund company is probably only going to let you buy mutual funds offered by the mutual fund company itself.

To help you understand more about a Roth IRA account as compared to mutual funds, the following will illustrate some scenarios. Seeing how an investor might open one of these tax-advantaged accounts in the real world will shed more light on how they work.

How a Roth IRA Works

A Roth IRA is a type of retirement account created by Congress. It differs from a Traditional IRA in several notable ways. Each year, Congress allows you to put aside a certain amount of money, up to a maximum that is known as the "contribution limit." The 2020 Roth IRA contribution limits are $6,000 per person for anyone 49 years or younger and $7,000 per person for anyone 50 years or older, which includes a $1,000 "catch-up" contribution allowance. 

Any money you contribute to a Roth IRA, up to the maximum for a given year, is not tax deductible. In this sense, it's just like adding it to a savings account. On the other hand, almost all forms of income within the Roth IRA, including dividends, interest, capital gains, and in some cases, rents, are completely tax-free. In exchange for this great deal, you aren't allowed to withdraw the profits until you reach 59.5 years old unless you meet one of the several exemptions. Otherwise, you'll get hit with a 10% penalty tax.

Imagine that throughout your lifetime, you invest your money in a Roth IRA. You end up with $5,000,000 in the account and put it all in corporate bonds at a time when they are yielding 7.5% for 10-year maturities. You'd be collecting $375,000 in interest every year within your Roth IRA. Under the present rules, as long as you were 59.5 years or older, you could withdraw that money—all $375,000 of it—and never pay a single penny in taxes. Or, if you wanted, you could withdraw the entire $5,000,000 tax-free (though this would be a mistake as it is better to keep the money within the Roth IRA and only take the investment income out as you need it). This is the reason the Roth IRA is, hands down, the best tool available for small investors.

Congress sets household income limits on eligibility for a Roth IRA. If you are single and make $139,000 or more per year in 2020, you are not eligible to contribute to a Roth IRA under the guidelines. If you are married, filing jointly, the income limit is less than $206,000 for 2020. If you fall into this category, you do have the option of contributing to a Traditional IRA, which doesn't have the eligibility income limits, then converting it to a Roth IRA. It's a bit of paperwork hassle but most financial institutions do it so often it's second nature. This is known as a "Backdoor Roth IRA".

Opening a Roth IRA at a Bank or Credit Union

Say that Elsa walks into her local credit union and opens a Roth IRA. The credit union doesn't have an investment division so it only allows her to contribute the money to certificates of deposit or a money market account. She can't buy any stocks, bonds, mutual funds, or real estate through this Roth IRA because the servicer (the credit union) doesn't offer it among its provided services.

To make it more complicated, some, but not all, banks and credit unions also have brokerage divisions that allow you to buy investments for your Roth IRA that include stocks, bonds, and mutual funds from other companies. Wells Fargo and Bank of America, by way of example, fall into this camp.

Opening a Roth IRA Directly with a Mutual Fund Company

Edward decides he wants to buy shares of the Tweedy Browne Global Value Fund, ticker symbol TBGVX. He goes to the mutual fund company's website, downloads an application, checks the "Roth IRA" box, and writes a check for $6,000, which is the maximum he is allowed to contribute in 2019 since he is only 33 years old. The mutual fund company opens a Roth IRA for him, but the only investments the account can hold are shares of funds managed by Tweedy, Browne & Co., LLC, the mutual fund manager. If he wanted to buy shares of a Vanguard S&P 500 Index Fund or Coca-Cola, he's out of luck.

Just like banks and credit unions, some, but not all, mutual fund companies also have brokerage divisions that allow you to buy investments for your Roth IRA that include stocks, bonds, and mutual funds from other companies. Vanguard and Fidelity, by way of example, fall into this camp.

Opening a Roth IRA Through a Direct Stock Purchase Plan

After a great deal of thinking, Jonas makes up his mind and chooses to spend the rest of his life buying shares of The Coca-Cola Company and holding them tax-free through a Roth IRA. He doesn't want to invest in any other stock or mutual fund, so he signs up for the direct stock purchase plan, which has a Roth IRA option. After completing the application, opening the account, and setting up a link between his checking account and Roth IRA, the beverage giant's transfer agent begins making automatic monthly withdrawals from his checking account to buy more shares of Coca-Cola at a very low cost; typically less than $2 per transaction. He never pays any taxes on his Coca-Cola dividends because the stock is held in the Roth IRA.

Opening a Roth IRA Through a Brokerage Firm

Perhaps the most popular option is to open a Roth IRA with a brokerage firm such as Charles Schwab, E-Trade, or T.D. Ameritrade. It works exactly like opening an ordinary brokerage account. With few exceptions, you can buy any stock you want, any bond you want, any mutual fund you want, or any exchange-traded fund you want, often for a commission well under $10 per trade. You could have a Roth IRA at Schwab that held Vanguard funds, shares of General Electric, and some certificates of deposit issued by a bank in your state. In addition to enjoying the convenience of having all of your information on a single account statement, many brokers will reinvest your dividends for free.

Article Sources

  1. Charles Schwab. "Roth IRA." Accessed July 20, 2020.

  2. Bank of America. "Individual Retirement Accounts (IRAs)." Accessed July 20, 2020.

  3. IRS. "Retirement Topics - IRA Contribution Limits." Accessed July 20, 2020.

  4. IRS. "Roth IRAs." Accessed July 20, 2020.

  5. IRS. "Publication 590-B (2019), Distributions From Individual Retirement Arrangements (IRAs)." Accessed July 20, 2020.

  6. IRS. "Amount of Roth IRA Contributions That You Can Make for 2020." Accessed July 20, 2020.

  7. Vanguard. "Roth IRA Income Limits: Your Compensation Counts." Accessed July 20, 2020.

  8. Wells Fargo. "Roth IRAs." Accessed July 20, 2020.

  9. Computershare. "The Coca-Cola Company: Direct Stock Purchase Plan." Accessed July 20, 2020.

  10. E-Trade. "Roth IRA." Accessed July 20, 2020.