Roth IRA vs. Index Fund: Which is Right For You?

Article Summary:

Roth IRAs and index funds (also known as index mutual funds) are two important tools when planning for your retirement, but that’s about all they have in common. A Roth IRA is a type of individual retirement account, and an index fund is a common type of investment product. Luckily the two are not mutually exclusive, so you don’t have to choose between a Roth IRA vs. an index fund. Instead, both can be employed as part of your investment strategy to grow your retirement savings.

If you’re like many people without a guaranteed pension, you need to save and invest for your retirement years through some type of retirement account. If your company doesn’t offer a 401(k) or similar investment, you’re probably in the market for a tax-advantaged individual retirement account (IRA) such as a traditional IRA or Roth IRA.

However, you may also decide to take some matters into your own hands and invest in an index fund or an actively managed mutual fund. But is one better than the other? Should you only invest in an IRA?

Today, we’ll take a look at the differences between the two IRA accounts and two possible investment options to help build wealth for your retirement: index funds or actively managed mutual funds.

Traditional IRAs vs. Roth IRAs

Both types of IRAs are designed to save money for retirement through stocks, bonds, and other investments, but the primary difference is how they’re taxed.

  • Traditional. A traditional IRA is (usually) funded with pre-tax dollars. When you start making withdrawals, you are taxed on those distributions just like regular income. But your contributions are tax-deductible, which saves you money in the short term.
  • Roth. A Roth IRA investment account, on the other hand, is funded with after-tax dollars and any potential earnings grow tax-free. Plus, when you start making withdrawals, that money is not taxed at all. Keep in mind, your contributions to a Roth IRA are not tax-deductible because you’ve already paid taxes on that money.

The bottom line is, if you can swing it, it’s not a bad idea to have one of each account. The traditional IRA can catch contributions from pre-tax money out of your paycheck, while a Roth IRA grows using any surplus cash you can contribute to it. Think of a Roth IRA as a supplemental, tax-free retirement savings account that is also a great investment vehicle.

Traditional IRARoth IRA
How fundedPre-tax dollarsPost-tax dollars
Contribution Limits$6,000 if under 50
$7,000 if 50 or older
$6,000 if under 50
$7,000 if 50 or older
Eligible WithdrawalsTaxed as IncomeNot taxed
Contributions tax deductible?YesNo

If you’re not sure which account is best for you, try speaking with an investment advisor. They may be able to steer you in the right direction for your retirement planning.

IMPORTANT! For the purposes of this article, we’ll focus on investment options for your Roth IRA. Specifically, we’ll discuss index funds versus actively managed funds, which can both take advantage of a Roth IRA’s tax efficiency. This is because your earnings from investments grow tax-free in this non-taxable account.

Actively managed mutual funds vs. index funds

Index funds and mutual funds are similar in that they are both investment options that contain a diverse basket of assets, such as stocks, bonds, and other securities. One of the biggest benefits of these types of investments is that they give you automatic portfolio diversification, which dilutes your investment risk, as compared to investing in individual stocks.

For example, if you invest $10,000 in a single company’s stock and that share price dramatically tanks, you could conceivably lose all or most of your principal investment in one fell swoop. If instead you invest in an index fund or actively managed mutual fund, your investment is spread out over many different securities. It’s possible, but highly unlikely, that all of those assets under one fund will lose money, which helps to minimize your overall risk.

However, investors should be aware that there are some important distinctions between an index fund and an actively managed fund before adding one (or both) to their investment portfolio. Namely, they each have different fees, management styles, and investment goals.

Index FundManaged Fund
Average Expense Ratio0.2%0.7%
How Fund ManagedPassivelyActively
Investment GoalMatch market index returnsSurpass market index returns
Fund HoldingsStocks, bonds, and other securitiesStocks, bonds, and other securities

Investment objectives

One of the major differences between an index fund and an actively managed fund is its investment objective. For instance, an index fund seeks to track or match the market index, such as the S&P 500, the Dow Jones Industrial Average, or the Nasdaq Composite.

For example, if an index fund was modeled on the S&P 500, which holds stock in (give or take) 500 of the largest corporations, it would own shares in a number of those companies. So, as the underlying index goes up or down, the index fund that tracks it does as well.

By contrast, actively managed mutual funds seek to beat returns in the benchmark index in both riskier and more conservative ways, depending on the individual fund’s holdings.

For instance, growth mutual funds are typically more stock-heavy and have the potential for higher returns, but they’re also riskier. Income funds, on the other hand, are meant to generate a steady income for investors — they invest in dividend-paying stocks, as well as more conservative fixed-income investments, such as bonds.

Pro Tip

It can be tricky to figure out which way to go, so you might want to talk to a certified financial planner or financial advisor to discuss your personal finance goals. With their help, you can decide which style of fund is better suited to your time horizon and risk tolerance.

Management of actively managed mutual funds vs. index funds

Another key difference between a mutual fund and an index fund is the way in which they’re managed. An actively managed mutual fund, as its name implies, is handled by an investment manager or group of fund managers, who are responsible for making decisions and trades to optimize the fund’s returns.

Part of the reason the fund has active management is that, as mentioned, mutual funds aim to beat the benchmark index (not just match it like with index funds). This requires continuous monitoring by a fund manager who may make frequent trades to try and surpass the index.

Index funds use a passive management strategy, which is the opposite of actively managed, and don’t require active managers or frequent trading to maintain the fund.

Fortunately, there’s a brokerage firm for whatever fund you prefer. Using the tool below, you can filter and compare different firms to find the brokerage that fits your needs.

Fees for index funds vs. mutual funds

Part of the deal when you buy into mutual funds or index funds is that they come with certain fees. These could be maintenance fees, management fees, and other expenses associated with the fund. The fees are expressed as a percentage and are known as an expense ratio.

Overall, actively managed funds tend to have higher expense ratios than index funds. This is mainly because managed funds require fund managers to actively manage the fund, unlike their passively managed counterparts.

Typically, the average expense ratio for managed funds is somewhere around 0.5% to 1.0%, whereas an index fund’s average expense ratio hovers around 0.2%. That said, these expense ratios can vary quite a bit.

It should be noted that expense ratios have steadily declined over the years, as reported by the Investment Company Institute (ICI). ICI reports that this shift can be attributed to three things: “Investor interest in lower-cost funds, industry competition, and economies of scale resulting from asset growth.”

This is good news for those who want to try their hand at mutual funds with active management. While a percentage point or less may not seem very significant on the surface, higher fees can take a bigger bite out of your earnings over the long term.

Chart of hypothetical investments with different expense ratios
Chart from U.S. Securities and Exchange Commission

A word on Roth IRA contributions

As you approach your retirement planning strategy, it’s good to know exactly how much the Internal Revenue Service (IRS) will allow you to contribute each year, so you can budget for building wealth. As of 2022, the contribution limits are $6,000 for an individual investor under the age of 50.

If you’re over 50, the 2022 contribution limits go up to $7,000, with that extra $1,000 being considered a “catch-up” contribution. The $7,000 after age 50 applies whether or not you’ve already added to your Roth IRA over the years. The contribution limits jump to $7,500 for 2023.

Also, remember that the contribution limits apply to all of your IRAs. So, if you have you have a traditional IRA and a Roth IRA, you can only contribute $6,000 or $7,000 across both accounts.

Pro Tip

If you have some extra income, consider opening a taxable brokerage account as part of your personal finance strategy. This is an investment account that you can easily access at any time if you need the money, unlike IRAs which shouldn’t be touched until retirement age.

FAQs

Do I need a Roth IRA account to invest in index funds?

It’s important to note that you don’t need to have a Roth IRA to invest in either index funds or actively managed mutual funds. These investments can be accessed in multiple ways besides a Roth IRA, including an employer-sponsored retirement program such as a 401(k), direct from mutual fund companies, or through a taxable brokerage account.

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

There is no limit to how many index funds or mutual funds a person can have in their Roth IRA or other retirement accounts. In fact, having more than one type of index or mutual fund is a great way to further diversify your retirement portfolio by exposing yourself to stocks, bonds, and other investments from a variety of different industries. You can also buy exchange-traded funds (ETF) to add to your investment mix.

What’s an exchange-traded fund (ETF)?

Exchange-traded funds are kind of like a cross between index funds and mutual funds. They often track a broad market index like index funds do (although they can also be more specialized), and like mutual funds they are sometimes actively managed funds as well.

However, the key difference with exchange-traded funds is that, unlike a mutual fund or index fund, ETF prices fluctuate throughout the day and can be traded all day long, just like individual stocks. This differs from index funds and mutual funds, which trade only once a day at the close of business.

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

Yes. That can be accomplished through either index funds or actively managed funds. You just have to search for index funds or managed mutual funds that specifically track the S&P 500 market index. If you’re unsure, you can always look to industry experts to see what they suggest.

Key Takeaways

  • A Roth IRA is a tax-advantaged investment account meant to build retirement income through investments. This includes stocks, bonds, and other securities, or funds that bundle a combination of those assets into one mutual fund or index fund.
  • Actively managed mutual funds have an investment manager or team to manage the fund. On the other hand, index funds employ a passive management strategy.
  • Index funds track a market index and aim to match it, while actively managed mutual funds try to beat the returns of the benchmark index.
  • Actively managed funds tend to have higher expense ratios, and index funds have comparatively lower expense ratios for investors.
  • Contribution limits for Roth IRAs in 2022 are $6,000 per year for individuals under 50, and $7,000 a year for those over 50. The contribution limits jump to $6,500 and $7,500 for 2023.
View Article Sources
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  14. 9 Less Talked About Ways To Save Big for Retirement — SuperMoney
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