Choosing Between Roth IRA and Mutual Funds

The secret? You don't have to choose.

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One 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 stocks, bonds, cash, and even mutual funds within 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 might only let you buy certificates of deposit or money market securities. A Roth IRA from a mutual fund company will probably only let you buy mutual funds offered by the mutual fund company itself.

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

Key Takeaways

  • A Roth IRA is a type of tax-advantaged retirement account that can hold a variety of investments, including mutual funds.
  • Congress sets annual contribution limits for your IRA based on your age and income, regardless of what types of investments you hold in it.
  • You can open a Roth IRA through a bank, mutual fund company, or brokerage firm, or by purchasing stock directly.
  • The types of investments you can hold in your IRA will be determined by the institution where you open the account.

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, you may put aside a certain amount of money, up to a maximum that is known as the "contribution limit." The 2021 and 2022 Roth IRA contribution limits are $6,000 per person for anyone age 49 or younger and $7,000 per person for anyone age 50 or older, which includes a $1,000 catch-up contribution allowance. 

Any money that you contribute to a Roth IRA, up to the maximum for a given year, is not tax deductible. In that 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 age 59 1/2 unless you meet one of the several exemptions. Otherwise, you'll get hit with a 10% penalty tax.

Imagine that throughout your lifetime, you were to invest your money in a Roth IRA. Suppose you were to end up with $5 million 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 1/2 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 that 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). That is why the Roth IRA is, hands down, the best tool available for small investors.

Roth IRA Eligibility Limits

Congress sets household income limits on eligibility for a Roth IRA. If you are single and make $140,000 or more per year in 2021 (increasing to $144,000 or more in 2022), you are not eligible to contribute to a Roth IRA under the guidelines. If you are married and filing jointly, the income limit is $208,000 for 2021 (increasing to $214,000 for 2022).

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, but most financial institutions do it so often that it's second nature. This is known as a "backdoor Roth IRA." Keep in mind that while there are no eligibility limits for traditional IRAs, income limits determine how much of your contribution is tax deductible.

Opening a Roth IRA at a Bank or Credit Union

Suppose Elsa were to walk 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 fall into this camp.

Opening a Roth IRA Directly With a Mutual Fund Company

Edward decides that 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 2021 since he is under age 50. 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 ever wants to buy shares of a Vanguard S&P 500 Index Fund or Coca-Cola, he will need to make other arrangements.

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 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. Jonas will never pay 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 holds 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.

Frequently Asked Questions (FAQs)

What is a Roth IRA?

A Roth IRA is a tax-free retirement savings account. The money you put into the account has already been taxed, and it grows tax-free in the account. There is also no tax when you take distributions during retirement. It's one of the best vehicles you can use for growing your retirement savings.

What is a mutual fund?

A mutual fund collects money from investors and uses that money to purchase shares in various stocks, bonds, and securities. There are many types of mutual funds, from stock-specific funds and bond-specific funds to others designed for specific target dates or income investing. They offer a way to achieve a diverse portfolio without making the effort to research and purchase every individual security.

How should I allocate my Roth IRA funds?

You can own nearly asset with a Roth IRA, but there are ways to make the most of what you do purchase. In particular, since a Roth IRA is tax-free, it can be wise to consider investments that would be taxed heavily during retirement. That makes a Roth IRA a great vehicle for investing in high-growth stocks, corporate bonds, and income-oriented stocks.