Choosing Between Roth IRA and Mutual Funds

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

Roth IRA vs Mutual Funds
You don't have to choose between a Roth IRA and mutual funds because a Roth IRA is a type of account, not an investment. You can even hold mutual funds within a Roth IRA if you want. DNY59 / E+ / Getty Images

Countless times a year, I receive messages from new investors asking something along the lines of, "Should I invest in a Roth IRA or mutual funds?".  The question can't be answered because 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 the already mentioned 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 why the entire idea of a Roth IRA vs. mutual funds is nonsensical, I'm going to run you through some scenarios.  By seeing how an investor might open one of these tax-advantaged accounts in the real world, you might be able to better understand how they work.

The Basics of 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".

I'll use the most recent Roth IRA contribution limits, which are $5,500 per person for anyone 49 years or younger and $6,500 per person for anyone 50 years or older.  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 fantastic deal, you aren't allowed to withdraw the profit until you reach 59.5 years old unless you meet one of the several exemptions.  Otherwise, you'll get slammed with a 10% penalty tax.

Let's imagine you successfully invest money in a Roth IRA throughout your lifetime.  You end up with $5,000,000 in the account and park it all in corporate bonds at a time when they are yielding 7.5% for 10-year maturities, which is around the average rate generated over the past few decades.  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 protective confines of 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 doesn't want everyone to have access to the Roth IRA so it sets household income limits on eligibility.  If you are single and make over $129,000 per year, you are not eligible to contribute to a Roth IRA under the guidelines.  If you are married, filing jointly, the amount is $191,000.  This is really a meaningless barrier because if you fall into this category, you can simply contribute to a Traditional IRA, which doesn't have the eligibility income limits, then convert 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

Elize 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 the services it provides.

To make it more complicated, some (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

Erston 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, writes a check for $5,500, which is the maximum he is allowed to contribute in 2014 since he is only 33 years old, and checks the "Roth IRA" box.  The mutual fund company opens a Roth IRA for him, but the only investments it 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.

To make it more complicated, some (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

Jude decides he wants to spend the rest of his life buying shares of The Coca-Cola Company, and hold them tax-free through a Roth IRA.  He doesn't want to invest in any other stock or mutual fund.  He signs up for the direct stock purchase plan, which has a Roth IRA option.  He selects it and the beverage giant's transfer agent begins making automatic monthly withdrawals from his checking account to buy more shares 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, opening a Roth IRA with a brokerage firm such as Charles Schwab, E-Trade, or T.D. Ameritrade 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.  Many brokers will reinvest your dividends for free and you enjoy the convenience of having all of your information on a single account statement.

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