There is a common question that new investors ask about whether they should invest in a Roth IRA or a mutual fund. This question cannot 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 is not a type of investment; it is a type of account. You can invest in assets such as stocks, bonds, cash, and even mutual funds within a Roth IRA.
How Does a Roth IRA Work?
A Roth IRA is a type of retirement account created by Congress. It differs from a traditional investment account in several notable ways. You can contribute a certain amount of money each year, up to the maximum known as the “Contribution Limit.” The contribution limits for a Roth IRA for 2022 are $6,000 per person for anyone under 49 years old and $7,000 per person for anyone aged 50 or older, which includes an additional $1,000 catch-up contribution. For the year 2023, the limits are $6,500 for those under 49 years old and $7,500 for those over 50 years old.
The money you contribute to a Roth IRA is not tax-deductible. It’s like adding it to a savings account in that regard. However, all forms of income within a Roth IRA, including dividends, interest, and capital gains, can grow completely tax-free.
Note that you cannot withdraw the earnings without paying taxes on them until you are 59 and a half unless you qualify for one of the exceptions. Otherwise, you will incur a 10% penalty tax. You must also keep the account for at least five years.
Imagine you invested in a Roth IRA throughout your life. Let’s say you ended up with $5 million in the account and put it all in corporate bonds at 7.5% for 10 years. You would earn $375,000 in interest each year within your Roth IRA.
You can withdraw all $375,000 of that money and not pay a dime in taxes on it under current rules, as long as you are 59 and a half or older and have kept the account for at least five years. Alternatively, you could withdraw the entire $5 million tax-free.
Eligibility Limits for Roth IRA
Congress sets income limits for eligibility to contribute to a Roth IRA. You will not be eligible to contribute to a Roth IRA under the 2023 guidelines if you are single and earn $153,000, or $228,000 for married couples filing jointly. For 2022, the limits are $144,000 for individuals and $214,000 for married couples filing jointly.
You have the option to contribute to a traditional investment account if you earn above that because traditional accounts do not have income eligibility limits. You can then convert the account to a Roth IRA. This is known as a “Backdoor Roth IRA.”
Although there are no eligibility limits for traditional accounts, the income limits may dictate how much of your contribution can be tax-deductible.
How to Open a Roth IRA
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different types of institutions have their own versions of Roth IRAs. A Roth IRA from a discount broker like Charles Schwab allows you to buy almost any type of investment, including stocks, bonds, and mutual funds. A Roth IRA from a bank may only allow you to buy certificates of deposit or money market instruments. A Roth IRA from a mutual fund company may only allow you to buy the mutual funds offered by that company.
Opening a Roth IRA at a Bank or Credit Union
Suppose you went to your local credit union and opened a Roth IRA. The credit union does not have an investment department, so it only allows you to contribute your money to certificates of deposit or a money market account. You cannot buy any stocks, bonds, mutual funds, or real estate through this Roth IRA because the service provided (the credit union) does not offer those services.
Some banks and credit unions have brokerage departments that allow you to purchase investments for a Roth IRA that include stocks, bonds, and mutual funds from other companies. Charles Schwab and Bank of America fall into this category.
Opening a Roth IRA Directly with a Mutual Fund Company
Now suppose you want to buy shares of the Tweedy, Browne Global Value Fund, which has the 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.
The mutual fund company opens a Roth IRA for you, but the only investments the account can hold are shares of the funds managed by Tweedy, Browne LLC, the mutual fund manager. You’ll need to make other arrangements if you want to purchase shares of the S&P 500 Index from Vanguard or buy shares of Coca-Cola.
Like banks and credit unions, some mutual fund companies have brokerage departments that allow you to buy investments for a Roth IRA that include stocks, bonds, and mutual funds from other companies. Vanguard and Fidelity fall into this category.
Opening a Roth IRA through a Direct Stock Purchase Plan
Now you’ve decided to spend the rest of your life buying shares of Coca-Cola 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 a 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 the Roth IRA, the transfer agent for the beverage company begins to pull monthly amounts automatically from your checking account to buy more shares of Coca-Cola at a very low cost. Usually less than $2 per trade. You won’t pay any taxes on your profits from Coca-Cola shares because the stock is held in a Roth IRA.
Opening a Roth IRA through a Brokerage Firm
Perhaps the most common option is to open a Roth IRA with a brokerage firm like Charles Schwab, E-Trade, or TD Ameritrade. It works exactly like opening a regular 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 of less than $10 per trade.
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For example, you may have a Roth IRA account at Schwab that contains Vanguard funds, General Electric stocks, and some certificates of deposit issued by a bank in your state. In addition to enjoying the convenience of having all your information in one account statement, many brokers will reinvest your earnings for free.
Frequently Asked Questions
What is a Roth IRA?
A Roth IRA is a tax-free retirement savings account. The money you put in the account has already been taxed and grows without being taxed within the account. There are also no taxes when you withdraw funds during retirement. It is one of the best tools you can use to increase your retirement savings.
What is a mutual fund?
A mutual fund pools money from investors and uses that
Source: https://www.thebalancemoney.com/roth-ira-vs-mutual-funds-358037
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