Should You Hold ETFs or Mutual Funds in Your IRA?

If you’ve held a company-sponsored 401(k) or 403(b), you know that your company gave you a false sense of freedom. You may have thought you were “free” to pick from any one of the handful of mutual funds that they picked for you. However, you also may not have had a lot of options to choose from.

With IRAs opened outside of your company, you have the choice of just about any investment option on the market. With all of this freedom, should you hold ETFs or mutual funds?

Understanding ETFs

Exchange-traded funds (ETFs) are investment vehicles that combine the features of both stocks and mutual funds. They function as a type of investment fund and are designed to provide investors with a simple and flexible way to gain exposure to a wide range of assets. ETFs are listed and traded on stock exchanges (just like individual stocks) so investors can easily buy and sell them.

One distinguishing feature of ETFs is that they are designed to track the performance of specific market indices, sectors, or asset classes. They do this by holding a diversified basket of assets that closely mirrors the composition of the index they are tracking. Therefore, investors can choose an ETF that closely mirrors their desired specifications; by investing in the ETF, they can simply own one type of fund but hold a diversified portfolio of underlying investments.

The creation and redemption process is fundamental to how ETFs operate. When an ETF is created, an authorized participant delivers a specified portfolio of the underlying assets to the fund in exchange for new ETF shares. This is usually a large institutional investor. This also helps demonstrate the visual of the “basketing” effect of ETFs.

Understanding Mutual Funds

Mutual funds operate similarly by collecting money from multiple investors and using those funds to invest in a diversified portfolio of stocks, bonds, or other securities. These funds are managed by professional portfolio managers or investment teams who make investment decisions on behalf of the investors. Mutual funds may distribute income and capital gains.

Investors purchase shares or units of the mutual fund. Their money is pooled together to invest across a broad range of assets. This diversification helps spread risk, reducing the impact of poor-performing individual investments. There are various types of mutual funds including equity funds, fixed-income funds, money market funds, and hybrid funds (which combine multiple types of funds).

Much like ETFs, mutual funds offer a convenient way for investors to access professional management and diversification, making them suitable for investors with various risk tolerances and investment objectives.

Similarities Between ETFs and Mutual Funds

Before we discuss the differences between the two and cover how each factor into IRA considers, let’s discuss how ETFs and mutual funds are similar. At their core, both ETFs and mutual funds offer investors diversification. They achieve this by pooling money from multiple investors and using it to invest in a portfolio of various underlying assets, such as stocks, bonds, or other securities.

Both types of funds are managed by professionals. These portfolio managers or investment teams are responsible for making investment decisions on behalf of the fund’s investors. As a result, both ETFs and mutual funds have fees and expenses associated with them.

Both ETFs and mutual funds provide liquidity to investors. This liquidity allows investors to access their investments easily, unlike some other investment types with limited trading windows or lack of active marketplaces. For this reason, both types of funds are subject to regulatory oversight to protect the interests of investors. Securities laws and regulations mandate reporting, disclosure, and operational standards for both ETFs and mutual funds.

Key Differences Between ETFs and Mutual Funds

With the similarities in mind, let’s dive into the differences. These items below will be the deciding factors in whether or not ETFs or mutual funds make better sense for your IRA.

Method of Trade

ETFs are traded on stock exchanges throughout the trading day, providing investors with intraday trading flexibility, while mutual funds are bought and sold at the end-of-day net asset value (NAV) price. This isn’t necessarily an issue for IRA investors either way, as an IRA isn’t traditionally used for active trading.

Cost Structure

ETFs typically have lower expense ratios due to passive management, tracking indices, and requiring fewer administrative costs. On the other hand, mutual funds can have higher expense ratios, especially when they are actively managed. Mutual funds may involve more research and hands-on management. When investing for a long period of time, these expenses can make a critical difference in evaluating long-term IRA earning potential.

Tax Efficiency

ETFs are often considered more tax-efficient as their structure minimizes capital gains distributions to investors. Meanwhile, mutual funds can generate capital gains within the portfolio which are distributed to investors, potentially resulting in taxable events. Note that the tax status may be different depending on the IRA you’ve decided to open.

Investment Amount

ETFs usually have no minimum investment requirements, making them accessible to investors with limited capital, while many mutual funds have minimum investment amounts that may be a barrier to entry for smaller investors. Even though you may be saving for retirement over a long period of time, you may only be able to contribute a little bit each period. If this is the case, you may not quality for mutual fund contributions.

Share Characteristic

Mutual funds are bought and sold at their NAV, which is calculated at the end of the day. ETFs trade just like stocks. You can buy and sell shares at any time during the day at the current price, which changes very rapidly. You can purchase one share of an ETF or millions and even fractional shares. Some brokers may let you purchase fractions of one share and allow you to purchase as many shares as you would like.

Management Style

This item was mentioned above, but it’s important so it gets it’s own callout here. ETFs are predominantly passively managed. Alternatively, mutual funds can be actively managed. Some investors may have a preference on how the fund is managed and the level of activity surrounding the investment.

Commissions

When you buy and sell a stock or ETF, you have to pay a commission to your broker. For most, this is a flat fee regardless of how many shares you buy or sell. Although it’s important to take these fees into account, the more shares of an ETF you purchase, the less the commission matters, since it becomes a smaller percentage of the trade. Increasingly, brokerage firms are adding no-commission ETFs to their line-up, which takes away this concern.

Sales Charges

ETFs generally do not have sales charges such as front-end or back-end loads. However, some mutual funds may impose sales loads, affecting the initial or final investment amount through upfront or redemption fees. Note that there are many no-load mutual fund options, though most ETFs are no-load.

Which Is Better for IRAs?

ETFs offer several advantages for IRAs. They often have lower expense ratios compared to mutual funds, which can result in higher long-term returns for your retirement savings. Additionally, ETFs are known for their tax efficiency, making them particularly well-suited for tax-conscious investors (opening up a tax-advantaged retirement account like an IRA).

ETFs are structured to lead to fewer capital gains distributions which can also reduce your tax liability when you eventually withdraw funds in retirement, though this may not be a factor depending on your IRA and it’s tax implications. Though ETFs are easier to trade during the day, this also isn’t really a factor when considering retirement savings in an IRA.

In the end, mutual funds have their place. However, because they are actively managed with often higher fees, their structure is usually less favorable to investors trying to maximize long-term retirement savings growth.

Traditional and Roth IRA Considerations

There are a couple of mutual fund and ETF considerations when picking between your IRA options. Choosing riskier and less expensive investment options for a Roth IRA over a traditional IRA can be a strategic move.

Because Roth IRAs offer tax-free withdrawals in retirement, you tend to want to maximize your earnings in this type of account. This tax-free status makes them an attractive choice for individuals with a long investment horizon and a higher risk tolerance. It also means that ETFs and their lower fees may generate more tax-free wealth over time.

The absence of required minimum distributions (RMDs) in Roth IRAs during the account holder’s lifetime adds another layer of flexibility. You can choose riskier options without the pressure of mandatory withdrawals, meaning you can select the riskier investment option as part of your broader portfolio diversification.

One angle to this is that ETFs are more often passively managed. This means a portfolio manager is not actively trying to beat benchmarks or targets. Therefore, you may consider putting your mutual fund in your Roth IRA should you feel more comfortable that the higher fees of that asset be more heavily outweighed by potentially higher income.

The Bottom Line

Because most actively managed mutual funds will fail to beat the market over a long period of time, paying the extra fees in loads and expense ratios may not be money well spent. Instead, consider the benefits of passively managed mutual funds or ETFs for your IRA. Both might have a place in your portfolio but because of the ease of buying and selling, and possibly more favorable tax treatment, many IRA investors likely find that ETFs better fit their goals and objectives than mutual funds.