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Roth IRA vs. Index Fund: 7 Key Differences Every Investor Should Know

Last updated 03/19/2024 by

Benjamin Locke

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Roth IRAs and index funds are two terms you might encounter when planning for retirement. Roth IRAs are tax-advantageous investment platforms while index funds are pooled investment vehicles that commonly operate inside a Roth IRA. Roth IRAs and index funds do not compete with each other but instead are part of a symbiotic relationship.
Sitting down to plan your investment and retirement goals is one of the most crucial ways to ensure you are financially secure in the future. If you are new to personal finance and retirement planning, you will probably encounter various acronyms and numbers that can seem confusing (401ks, IRAs, ETFs, etc.). Your retirement planner or financial advisor may mention mutual funds or index funds as well. If you are confused about which to choose, a Roth IRA or an index fund, don’t worry. They work in conjunction with each other, so you can have both!
Inside a Roth IRA, you can hold multiple investments, including index funds (a grouping of stocks and securities that track an index like the S&P 500). Index funds and their ETF manifestations are increasingly common choices in modern-day investment and retirement planning.

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Index funds in brief

Index funds are collections of stocks and securities that track a specific market index. They can track a large index, such as the S&P 500 or the Nasdaq, or a small index, such as gold-related stocks. Index funds are passively managed. This means there is not an active investment manager buying and selling the underlying assets, as with a mutual fund. Instead, the basket of stocks and securities merely tracks whichever index it has been linked to. Due to this strategy, index funds have some of the lowest expense ratios of any investment product, particularly when compared to an actively managed fund.
Many people are familiar with index funds that are packaged into exchange-traded funds, or ETFs. ETFs can be bought and sold on the market, like any stock or security. The fundamental key to index funds is that they don’t try to beat the market; they simply track it. Although this might not sound as proactive as having a fund manager buying and selling with “insider” knowledge, the proof is in the pudding. Over the last 10 years, for example, the majority of actively managed funds have failed to beat the market. Thus, more and more people are choosing to track indexes rather than paying someone to beat the market.

Roth IRA in brief

Roth IRAs are government-sponsored savings accounts that have significant tax advantages, as they are designed to be used for retirement planning and savings. Unlike a normal taxable brokerage account, a Roth IRA account can grow and be withdrawn tax-free. You contribute to Roth IRAs with your after-tax income, and all federal and state income taxes need to be paid beforehand.
Roth IRAs have the following features:
  • Contribution limits: $6,000 (as of 2022), or $7,000 if you are over 50
  • Tax-free growth and withdrawals
  • Timeline to liquidate: 59.5 years old
  • Income eligibility
A Roth IRA differs from a traditional IRA in that you pay taxes on your contribution rather than your withdrawals. Traditional IRAs give you a break upfront and then hit you with a tax bill when you retire.

Pro Tip

If you make an income high enough that you feel it might be better to contribute with pre-tax dollars, then you should look into a traditional IRA. Traditional IRAs can also house index funds, just like Roth IRAs.

Differences between index funds and IRAs

Now you know that a Roth IRA and an index fund are completely different entities. To review, below are some key differences between Roth IRAs and index funds.
Index fundRoth IRA
ClassInvestment productInvestment platform
StructurePortfolio of stocksRetirement account
Contribution limitsUnlimited, unless restricted by a tax-advantaged plan (such as a Roth IRA)Annual limit ($6,500 in 2023)
Time horizonAnyRetirement
Tax advantagesNo, unless in a plan like a Roth IRAYes
AvailabilityGlobalU.S. only
EligibilityNoneEarned income, contribution limits

How do they differ?

Contribution limits

A Roth IRA has contribution limits, whereas an index fund or ETF that is not part of a Roth IRA has no individual limit. Index funds will be more than happy to take as much money as you have available. Roth IRA contributions are limited to $6,000 a year (as of 2022), or $7,000 if you are over 50.

Who can invest

Anyone with money can invest in an index fund. However, to invest in a Roth IRA, you need three qualifications to be eligible. First, you need to be an American resident. There is no Roth IRA in Singapore, for example. Second, you must earn the money from working, not a gift. And third, your modified adjusted gross income needs to be at or under a certain number ($144,000 for a single filer and $215,000 for joint filers as of 2022).
Looking for an advisor that can get you started with investment accounts? Here are some investment advisors that can help.

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When can you liquidate?

Index funds (not in a Roth) can be liquidated at any time you want. But with a Roth IRA, the funds can’t be liquidated without significant penalties until you are 59.5 years old. With an index fund, you can invest today and liquidate tomorrow with no penalty. As Roth IRAs are specifically geared for retirement, however, you have to wait.

Pro Tip

Although the law states you must be 59.5 years of age before you can withdraw from a Roth IRA, there are exceptions. College expenses and the birth of a child are some of the potential exemptions to ask your tax preparer about.

Tax advantages

An index fund has no tax advantages unless it is put into a tax-advantageous wrapper or platform, such as a 401k or Roth IRA. A Roth IRA, on the other hand, lets the money grow and be withdrawn tax-free.

Roth IRAs and index funds, a symbiotic relationship

If you are looking at an investment brochure for an index fund and an investment brochure for a Roth IRA, imagine them holding hands. In reality, Roth IRAs and index funds can be friends who work together to make your retirement plans as tax advantageous and seamless as possible.
Remember, Roth IRAs are not investment products; they are a platform that contains different investment products. Roth IRAs can contain mutual funds, index funds, alternative funds, stocks, and a whole slew of other investment-related products. Index funds, or ETFs, have become popular choices to put inside an IRA, so it doesn’t sit there lonely.

Why put an index fund in my Roth and not something else?

You should always try to diversify your portfolio, so ideally there should be multiple investment vehicles housed inside your Roth IRA. The advantage of index funds is that tracking the index often works. Upwards of 80% of actively managed funds, including mutual funds, do not beat the markets in which they trade. Furthermore, remember that although you pay no tax on your Roth IRA earnings, you may have to pay fees on the products that are held in your Roth IRA. Index funds have some of the lowest fees and expense ratios around. Explore your options with these brokerages.

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Do you need a Roth IRA to invest in index funds?

No, anyone from any country can invest in index funds or ETFs. Index funds can be part of your Roth IRA, though.

Why is a Roth IRA better than a mutual fund?

Just like Roth IRAs are different from index funds, they are different from mutual funds. A Roth IRA is a tax-advantaged retirement account that can hold mutual funds, index funds, and a variety of other financial instruments. You may consider a mutual fund invested in a Roth IRA to be better than a separate mutual fund if you prefer to pay taxes when you invest the money as opposed to when you withdraw it.

Should you invest in stocks or a Roth IRA?

Everyone in the U.S. could benefit from tax-advantageous platforms, such as a Roth IRA, a traditional IRA, or a 401k. Inside those platforms, people can hold stocks and funds. If in doubt, consider talking to a certified financial planner before deciding where to invest.

Can I invest in the S&P 500 with my Roth IRA?

Yes, you can buy individual stocks that are part of the S&P 500 or invest in mutual funds or ETFs that track the S&P 500 within your Roth IRA.

How many index funds should I have in my Roth IRA?

If your index funds are already diversified, as with the ones that track the top indexes, you may not need many. You might want to talk to a financial advisor about your asset allocation.

Key takeaways

  • Roth IRAs and index funds are two common terms you will come across when planning for retirement.
  • Roth IRAs are government-sponsored investment platforms, whereas index funds are financial products that can be put inside the platform.
  • Roth IRAs and index funds have some differences, such as who can contribute, how much they can contribute, and how they can liquidate the funds or exit.
  • Roth IRAs and index funds form a symbiotic relationship that can be utilized for smart retirement planning.

SuperMoney may receive compensation from some or all of the companies featured, and the order of results are influenced by advertising bids, with exception for mortgage and home lending related products. Learn more

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