Choosing Between a Roth IRA and Mutual Funds

The secret? You don't have to choose

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A common question asked by new investors is whether they should invest in a Roth IRA or a mutual fund. It really can't be answered because it's like comparing an apple to an orange. There are several differences between a Roth IRA and a mutual fund. Unlike a mutual fund, a Roth IRA isn't a type of investment. It's a type of account. You can hold investments such as stocks, bonds, cash, and even mutual funds within a Roth IRA.

Knowing how an investor might open one of these tax-advantaged accounts will shed more light on how they work and help you understand more about Roth IRA accounts as compared to mutual funds.

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, a mutual fund company, a 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. You can put aside a certain amount of money each year, up to a maximum that's 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.

The money you contribute to a Roth IRA isn't tax-deductible. It's like adding it to a savings account in this respect. But almost all forms of income within the Roth IRA, including dividends, interest, and capital gains, can grow completely tax-free.

Note

You can't withdraw the profits tax-free until you reach age 59 1/2 unless you qualify for one of several exemptions. Otherwise, you'll be hit with a 10% penalty tax. You must also hold the account for at least five years.

Imagine that you were to invest your money in a Roth IRA throughout your lifetime. Suppose you ended up with $5 million in the account and put it all in corporate bonds at a time when they were yielding 7.5% for 10-year maturities. You'd be collecting $375,000 in interest every year within your Roth IRA.

You could withdraw all $375,000 of that money and never pay a single penny in taxes on it under the present rules, as long as you were age 59 1/2 or older and held the account for at least five years. Or you could withdraw the entire $5,000,000 tax-free.

Roth IRA Eligibility Limits

Congress sets income limits on eligibility to contribute to a Roth IRA. You aren't eligible to contribute to a Roth IRA under the guidelines in tax year 2022 if you're single and earn $144,000 or more. This is up from $140,000 in 2021. The income limit was $208,000 for 2021, increasing to $214,000 in 2022 for married taxpayers who file jointly.

You do have the option of contributing to a traditional IRA if you earn more than this because traditional IRAs don't have eligibility income limits. You can then convert the account to a Roth IRA. This is known as a "backdoor Roth IRA."

Note

While there are no eligibility limits for traditional IRAs, income limits determine how much of your contribution is tax-deductible.

How To Open a Roth IRA

Different types of institutions offer their own versions of Roth IRAs. A Roth 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.

Opening a Roth IRA at a Bank or Credit Union

Suppose you were to walk into your local credit union and open a Roth IRA. The credit union doesn't have an investment division, so it only allows you to contribute your money to certificates of deposit or a money market account. You can't buy any stocks, bonds, mutual funds, or real estate through this Roth IRA because the servicer (the credit union) doesn't offer these among its provided services.

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

Now let's say that you want to buy shares of the Tweedy, Browne International Value Fund, ticker symbol TBGVX. You go to the mutual fund company's website, download an application, check the "Roth IRA" box, and write a check for $6,000. This is the maximum you're allowed to contribute in 2022 because you're under age 50.

The mutual fund company opens a Roth IRA for you, but the only investments the account can hold are shares of funds managed by Tweedy, Browne & Co., LLC, the mutual fund manager. You'll have to make other arrangements if you ever want to buy shares of a Vanguard S&P 500 Index Fund or Coca-Cola.

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

Now you decide to spend the rest of your life buying shares of The Coca-Cola Company and holding them tax-free through a Roth IRA. You don't want to invest in any other stock or mutual fund, so you sign up for the direct stock purchase plan that has a Roth IRA option.

After completing the application, opening the account, and setting up a link between your checking account and Roth IRA, the beverage giant's transfer agent begins making automatic monthly withdrawals from your checking account to buy more shares of Coca-Cola at a very low cost. They're typically less than $2 per transaction. You'll never pay any taxes on your 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. You can typically 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's 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 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 you allocate Roth IRA funds?

You can own nearly any asset within a Roth IRA, but there are ways to make the most of what you purchase. It can be wise to consider investments that would be taxed heavily during retirement because a Roth IRA is tax-free if you meet the rules. That makes a Roth IRA a great vehicle for investing in high-growth stocks, corporate bonds, and income-oriented stocks.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Internal Revenue Service. "Retirement Topics - IRA Contribution Limits."

  2. Internal Revenue Service. "Publication 550 (2021), Investment Income and Expenses."

  3. Internal Revenue Service. "Roth IRAs."

  4. Internal Revenue Service. "Publication 590-B, Distributions From Individual Retirement Arrangements (IRAs)."

  5. Internal Revenue Service. "Income Ranges for Determining IRA Eligibility Change for 2021."

  6. Internal Revenue Service. "2022 Limitations Adjusted as Provided in Section 415(d), etc.," Page 4.

  7. Internal Revenue Service. "Traditional and Roth IRAs."

  8. Internal Revenue Service. "IRA Deduction Limits."

  9. Bank of America. "Individual Retirement Accounts (IRAs)."

  10. Wells Fargo. "IRA – Frequently Asked Questions."

  11. Tweedy, Browne Company. "International Value Fund (TBGVX)."

  12. Fidelity. "Investing Ideas for Your IRA."

  13. Vanguard. "Pick Investments for Your IRA."

  14. Charles Schwab. "Roth IRA."

  15. Investor.gov. "Mutual Funds."

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