ETF vs. Mutual Fund: Which One is Right for Your Portfolio?

When it comes to your investment portfolio, diversification is the best strategy.

ETF vs. Mutual Fund

Unfortunately, many people struggle when it comes to finding diversified investments that meet their financial goals. According to a Bankrate survey, 23% of Americans listed cash as the best way to invest money they wouldn’t need for a while, compared with just 17% who prefer stocks.

One of the troubles is deciding which types of investments to include for the best performance. Consider the two popular options: ETFs, or exchange-traded funds, and mutual funds.

ETF and Mutual Fund Comparison

Both ETFs and mutual funds involve pooling money and using it to buy a mix of different assets. Depending on the ETF or mutual fund you select, a single purchase could gain exposure to a broad range of various assets. When it comes to your portfolio, is an ETF or a mutual fund a better investment choice? In order to properly compare mutual funds and ETFs, it’s important to understand each investment individually.

What is an ETF?

An exchange-traded fund, or ETF, is a collection of securities bundled together in a single basket. Common assets you might see are stocks, bonds, and commodities, or some combination of the three. Grouping these different securities into a single basket makes them more attractive because it delivers an almost automatic diversification.

The redemption and creation of ETSs come in larget lots. The shares trade throughout the day directly between investors on the open market. This gives you the added value of transparency because their holdings are generally disclosed daily.

ETFs come in a wide variety, and you can use the different funds to accomplish clear investment goals. Two examples are market ETFs, which are designed around a particular index such as the S&P 500 or NASDAQ, and bond ETFs that provide exposure to bond investments like the ones you’ll find in the U.S. Treasury, corporate, international, and more.

What is a Mutual Fund?

Mutual funds are a collective pool of money used to invest in various securities like stocks and bonds. Once you buy shares, you get a claim to the profits from the investments contained in the fund. Due to the combined nature and the distribution of expenses, every shareholder in a mutual fund shares equally in the value of gains and losses.

Mutual funds aren’t bought and sold by individual investors, which is an added benefit of including them in your portfolio. Instead, a money manager who has the professional skill and time available to allocate your funds better, handles the funds.

The fund manager uses your money to buy into various securities according to your investment goals like long-term growth or fixed income. Some funds are riskier than others, but the diversity of assets in a mutual fund keeps the risk relatively low.

See Also: 15 Passive Income Ideas to Make Money While You Sleep

Pros and Cons of an ETF vs. Mutual Fund

Since both ETFs and mutual funds are made up of a mix of assets, the two are similar in structure. Though there’s no perfect fund, you need to understand the best and worst of each before deciding which is right for your portfolio.

Pros and Cons of ETFs

You can utilize ETFs for short-term trading, long-term trading, or a combination of both. Here are the advantages and disadvantages of including exchange-traded funds in your investment strategy.

ETFs

Pros and Cons of Mutual Funds

Buying a mutual fund is a relatively simple process. Banks and brokerage firms often have their own line of in-house options and include a wide range of asset classes and strategies. Here’s an overview of the pros and cons to consider with mutual funds.

ETFs

See Also: This Socially Conscious Company Helps You Invest in the Things That Matter

Differences Between ETFs vs. Mutual Funds

ETFs vs. Mutual Funds

Both ETFs and mutual funds are an easy avenue to invest in stocks and bonds. When deciding between the two, here are some of the factors you should consider before investing.

Management

Perhaps the most significant advantage of a mutual fund is that it’s more actively managed than most ETFs. With an actively managed fund, you gain access to the professional insight and skill of a professional money manager. They use their knowledge to attempt to beat the market and aim for a better return by buying and selling stocks on your behalf.

Actively managed ETFs exist, but they usually come at a much higher price. Most ETFs are passive, and they’re set up to automatically track an index such as the S&P 500 or the NASDAQ.

Trading

The best part of an ETF is the enhanced flexibility over mutual funds when it comes to trading. The investor and fund handle ETF sales directly rather than going through a professional manager.

ETF prices fluctuate throughout the day according to market demand. This is different than the cost of a mutual fund, which is set at the end of the business day when the net asset value (NAV) is determined.

Fees and Expenses

Mutual funds often come with higher fees because most are actively managed by an experienced person or group of professionals. The costs of owning an ETF are typically lower, though buying and selling can get expensive.

You can trade an ETF at any time during a trading day, and you’ll pay a commission for each trade you make. Mutual fund trading happens after the markets close, which leads to limited expenses.

Tax Efficiency

Investors have to pay taxes on capital gains and dividend income for mutual funds and ETFs since they’re both treated the same by the IRS. However, mutual funds are subject to more frequent taxable events than exchange-traded funds.

The manager of a mutual fund is continuously rebalancing the assets to distribute them properly or to accommodate shareholder redemptions. Asset sales, in this case, become a taxable event. For ETFs, the underlying securities aren’t sold because the shares are traded directly between investors. This process usually excludes the exchange as a taxable event, making them more tax efficient overall.

Investment Minimums

Many mutual funds have high investment minimums, making it a challenge to add them to your portfolio if you don’t have a lot of money saved. Even less experienced investors who are saving for specific goals through target-date mutual funds often have to meet a minimum investment of $1,000 or more.

ETFs typically don’t have a minimum investment requirement, and you can buy as little as a single share to add to your portfolio. This low barrier to entry makes it an excellent option for small investors who are looking to include ETFs in their portfolio.

Liquidity

Since the liquidity of a particular investment represents how quickly it can be converted to cash, ETFs are considered more liquid than mutual funds.

An ETF is adaptable to short-term trading, mostly due to a higher number of shares traded throughout the day and the ability to buy and sell at any time the exchange market is open. Having the option to enter and exit ETF positions quickly makes the liquidity of this type of fund higher.

Mutual funds are less flexible because the trading is done only once per day after the markets close. While this is a great option for long-term investors, this limited period to buy and sell mutual funds reduces the liquidity.

See Also: 7 Investment Strategies for 30 Year Olds and Tips to Get Started

ETF vs. Mutual Fund Performance FAQs

When considering an ETF or mutual fund, here are answers to some common questions about performance and safety you’ll ask yourself.

Do ETFs Pay Dividends?

If you own shares of an ETF, you receive dividends based on the number of shares you own relative to the number of shares in the fund. Some dividends pay interest instead, such as in fixed-income ETFs. However, most do offer a payout, and you’ll get a dividend each quarter.

Which is Safer, ETFs or Mutual Funds?

Whether an ETF or mutual fund is safer depends on your individual goals. There’s no such thing as a safe investment, but there are strategic advantages to each that you should consider.

To determine an investment’s safety, evaluate the mangament of the fund, the fees and expenses involved, the performance history and the types of underlying assets contained in the fund.

Which One is Better for Long-Term Investing?

There isn’t one clear winner when it comes to deciding if an ETF or mutual fund is better for long-term investing. ETFs are generally better for short-term investing because they can be traded multiple times during the day on an open market. Though their tax efficiencies make ETFs a good option for long-term investing, too.

Mutual funds can only be traded once per day after the market closes, making them less adaptable to short-term investing. But considering a short-term investment is one you hold for a year or less, you can easily apply this investing strategy to mutual funds.

ETF or Mutual Fund: Which Should You Choose?

When it comes to investing, there is no one-size-fits-all solution. Mutual funds and ETFs are both suitable choices to diversify your portfolio. You’ll want to consider your tax strategy, how much you can spend, and if you’re going to be more hands-on or would rather leave it to a professional money manager.

Overall, it depends on your individual investment goals. There’s more selection to choose from when it comes to buying a mutual fund, but ETFs have more flexibility because they’re traded like stocks. As you evaluate your options, you’ll see how each might impact your investment process. This will help you pick the perfect fund for your portfolio.

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401(k) vs. IRA: How to Choose The Best Retirement Account for You

Building a nest egg for retirement is like planting a tree.

401(k) vs. IRA

If you plant it early enough and regularly give it water, you can expect a full grown tree by the time you’re ready to retire.

But if you want that tree to grow as large as possible, you need to plant it in the right kind of soil. In other words, you need to choose the right kind of retirement plan before you start contributing. For most consumers, that means picking between a 401(k) vs. IRA.

The details of each type of retirement account may get a little complicated, but choosing the right fit is actually pretty simple. Here’s what you need to know.

Traditional 401(k) Roth 401(k) Roth IRA Traditional IRA
Limits $19,000 and an extra $6,000 for workers over 50. $19,000 and an extra $6,000 for workers over 50. $6,000 and an extra $1,000 for workers over 50. $6,000 and an extra $1,000 for workers over 50.
Key Pros Large contribution limit. Possibility of an employer match. Bigger contribution limit than IRAs. Withdrawals are tax-free in retirement. Tax-free retirement withdrawals. No RMDs in retirement. Contributions are tax-deductible.
Key Cons Fund options may be limited. No tax deduction. RMDs are required. Contributions are limited for those above a certain income. Contributions limited to $6,000 a year. Withdrawals are taxed.
Best For Employees with a company match and 100% vesting. Young workers who want to save more for retirement. Those who want to start investing but don’t have access to a 401(k). High-earners looking for more deductions or self-employed workers without access to a 401(k).

Individual Retirement Account (IRA)

An Individual Retirement Account (IRA) is a retirement account that any individual can contribute to. Any money contributed to an IRA must be earned while working a job. There are two types of IRAs, Roth and traditional.

Both types of IRA have the same maximum annual contribution limit of $6,000, and both allow an annual catch-up contribution of $1,000 for those 50 or older. IRAs are popular because customers can pick exactly what they want to invest in. They can choose between individual stocks, mutual funds or target date funds.

See Also: Roth vs. Traditional IRAs: What You Need to Know

Traditional IRA

A traditional IRA, like a traditional 401(k), allows investors to deduct contributions on their taxes. If you save the maximum $6,000 in your IRA, you can deduct $6,000 from your taxable income.

The tax deduction associated with a traditional IRA is the main advantage over a Roth IRA. Consumers with high incomes or business owners who want to decrease their taxable income will benefit the most from a traditional IRA. Because traditional IRA users get a tax break now, they have to pay income tax on their traditional IRA withdrawals in retirement.

A major drawback to traditional IRAs is their required minimum withdrawal (RMD). An RMD is how much you’re legally obligated to withdraw from your traditional IRA every year after you turn 70.5. The annual amount changes based on your total traditional IRA balance, your age, if you’re married, who your main beneficiary is, and how old your spouse is.

Let’s say you have $1,000,000 in your traditional IRA. You’re 71 years old and your spouse is also 71. According to the Vanguard RMD calculator, your RMD for 2019 would be $51,282.

Whichever investment company you use to hold your traditional IRA should be able to tell you how much your RMD is for each year. Not taking your RMD or taking less than is required will result in a penalty that’s 50% of the difference between what you withdrew and what your RMD was.

Roth IRA

A Roth IRA is a retirement account that provides tax-free withdrawals in retirement. Investors who contribute to a Roth IRA won’t receive a tax break while they contribute, but they won’t have to pay taxes on their withdrawals later on.

Roth IRAs also don’t have RMDs and are the only retirement account on this list without them. The Roth IRA is extremely popular because it allows investors to avoid taxes in retirement while they’re living on a fixed income.

Unfortunately, the IRS limits Roth IRA contributions to those who earn below a certain amount. Those filing single can contribute to a Roth IRA if they earn below $122,000 a year. Contributions start to phase out for individuals earning between $122,000 and $137,000. Anyone making $137,000 a year or more isn’t eligible to contribute to a Roth IRA.

Married couples filing jointly who make less than $193,000 a year can contribute to a Roth IRA, and contributions begin to phase out for incomes between $193,000 and $203,000. Couples making more than $203,000 are excluded from contributing to a Roth IRA.

Employer 401(k)

A 401(k) is an employer-sponsored retirement account available to employees as a company benefit, used to encourage employees to save money for retirement. Like health insurance and paid time off, individual companies have the right to decide if they want to offer a 401(k).

There are two types of 401(k)s, Roth and traditional. Like with IRAs, a traditional 401(k) has tax-deductible contributions and a Roth 401(k) has tax-free withdrawals in retirement.

The most important advantage with a 401(k) is the possibility of a company match. Some employers will contribute money to their employees’ 401(k) account. This is basically free money that an employee can use for retirement.

Matching contributions vary based on company policy. Some companies require that employees contribute a certain amount before the employer match kicks in. Others contribute to 401(k)s without an employee requirement.

Many companies have a vesting period, which dictates when employer contributions become the employee’s legal property. A five-year graded vesting schedule means an employee has to stay five years to earn 100% of the employer contributions. If they leave two years in, they’ll earn 40% of the contributions and forfeit the rest.

401(k)s come with a huge annual contribution limit. That limit is $19,000 in 2019, with those 50 or older able to contribute an extra $6,000 a year. That makes it one of the largest contribution limits available for all retirement accounts.

One disadvantage of 401(k)s is that the employer has complete control over what funds are available. Companies can offer a small handful of funds or a large variety. It’s also common for 401(k) funds to have high fees that eat away at investor profits. The only way to avoid bad fund options is to petition your HR department to offer a better variety.

Another drawback is the vesting schedule, which can keep an employee tethered to a job longer than they want.

Traditional 401(k)

A traditional 401(k) can decrease your taxable income and reduce how much you pay in taxes. That’s why people with high incomes opt for a traditional 401(k) in lieu of a Roth.

Employees will still owe taxes on withdrawals. Like traditional IRAs, individuals 70.5 or older must start taking RMDs.

Roth 401(k)

The Roth 401(k) is a relatively new product, and many employers still don’t offer them. It combines the best aspects of a Roth IRA and a 401(k) – the tax-free withdrawals in retirement offered by a Roth IRA and the higher contribution limit of a 401(k).

Unlike Roth IRAs, Roth 401(k)s do have RMDs when the retiree turns 70.5. These can be avoided by converting the Roth 401(k) into a Roth IRA. Make sure to do this before you turn 70.5.

See Also: 7 Investment Strategies for 30-Year-Olds and Tips to Get Started

Opening Both an IRA and 401(k) May Be the Best Option

Choosing between an IRA and 401(k) can seem difficult to a novice investor, but there’s no wrong decision here. There are benefits to both plans, and many investors find it useful to have an IRA and 401(k). If you’re struggling to decide between a Roth or traditional plan, you can also have one of each and contribute to both.

Some investors will contribute enough to a 401(k) to earn a company match and then open an IRA. For example, if your employer contributes 50% of what you put in, up to 6% of your salary, you can contribute that amount to get the company match. If you still have money left over, you can open an IRA and put any extra funds there.

The only truly wrong decision is to wait and delay picking a plan because you’re not sure which one is the best. When it comes to saving for retirement, the most important thing is contributing early and often.

If you’re having trouble deciding on your own, you can hire a financial planner to explain what your options are and what makes the most sense. They’ll be able to design a strategy that fits your specific situation.

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Roth IRA vs. Traditional IRA: What You Need to Know

Roth vs. traditional: How to choose

The biggest difference between a Roth and a traditional IRA is how and when you get a tax break: The tax advantage of a traditional IRA is that your contributions are tax-deductible in the year they are made. The tax advantage of a Roth IRA is that your withdrawals in retirement are not taxed.

Thus most advice on the Roth IRA versus traditional IRA topic begins with a question: Do you think your tax rate will be higher or lower in the future?

If you can answer that question definitively, you can theoretically choose the type of IRA that will give you the biggest tax savings: If you expect your tax rate to be higher in retirement, choose a Roth IRA and its delayed tax benefit. If you expect lower rates in retirement, choose a traditional IRA and its upfront tax advantage.

One problem: It’s hard to anticipate what your tax rate will be in retirement, particularly if you’re decades away from leaving the workforce.

Fortunately, there are other ways to determine whether a Roth or traditional IRA is best for you.

With so many options to choose from, it can be hard for even seasoned financial experts to figure out the best route. For many consumers, it’s better to just open a retirement account through your employer and be done with it.

But that’s not an option for everyone. With more than 50% of the American workforce predicted to become freelance workers in the next decade, there’s a very real need for solid, standalone retirement savings options. That’s why the Individual Retirement Account (IRA) has become so popular.

An IRA allows you to plan for retirement without the backing of an employer, making it perfect for freelance IT experts, consultants, writers, gig economy workers, and almost anyone else with a nontraditional employment situation. Some consumers even opt to use an IRA instead of an employer-sponsored plan with lackluster investing options.

The IRA comes in two flavors: Roth IRA vs. traditional IRA. Here’s what you need to know about both.

What is an IRA?

An IRA, or individual retirement account, is a retirement savings plan that any person can open on their own. Unlike a 401(k), an IRA doesn’t have to be sponsored by an employer. That makes them especially popular with the self-employed and gig economy workers.

Consumers usually open IRAs because they don’t have access to an employer account, or because their 401(k) has poor investment options. Some open IRAs because they need to roll over a 401(k) from a former employer into a new account and aren’t yet eligible for a 401(k) from their new company.

Contribution limits for IRAs in 2019 are $6,000 per year and usually come with cost-of-living increases every year. Investors 50 or older can contribute an extra $1,000 per year.

Money contributed to an IRA must be earned income, and your salary must equal or exceed your contribution. If you only make $5,000 a year, for instance, you can’t contribute the full $6,000 limit.

Parents can open an IRA for their children, as long as the child contributes his or her own earned money. If your kid is 15 and works as a lifeguard at the pool, for example, they can contribute that money to an IRA. The parent will have access to the account until the child becomes a legal adult.

Opening an IRA is like opening a new bank account. First, you need to choose an investment firm. The most popular companies are Charles Schwab, Morgan Stanley, Fidelity, and Vanguard.

Robo advisors such as Betterment, Wealthfront, and Wealth Simple also provide IRAs if you want a more hands-off approach. These companies will choose which funds to invest in and may even suggest how much you should save for retirement. Some robo advisors even offer phone consultations with a human financial advisor for those who don’t want to completely entrust their wealth to an algorithm.

You can also pick a target-date fund, which is based on when you hope to retire. A target-date fund rebalances your portfolio over time. A 30-year-old who picks a 2055 target-date fund will start off with a fund mostly invested in stocks. As he or she gets older, the fund will rebalance to invest more heavily in bonds.

To fund your IRA, you can link your bank account and set up regular automatic contributions to a mutual fund, stock, or exchange-traded fund.

Roth IRA vs. Traditional IRA

Roth IRA vs. Traditional IRA

If you’ve decided to open an IRA, the next step is to choose between a Roth IRA or a traditional IRA.

Roth IRA

The best part of choosing a Roth IRA is knowing that you won’t owe taxes when you withdraw funds in retirement. Contributing to a Roth IRA is like delayed gratification. You don’t get an immediate tax break, but you’ll get a boost when you start taking money out in retirement.

Another advantage to the Roth IRA is its usefulness as a wealth transfer tool. If you leave a Roth IRA in your will, your heirs won’t have to pay income tax on the funds as long as the account was open for more than five years.

A Roth IRA is only available for those below a certain income threshold. In 2019, married couples earning less than $193,000 can contribute the full $12,000 limit. Those earning between $193,000 and $203,000 can contribute a lesser amount. Couples earning more than $203,000 can’t contribute to a Roth IRA at all.

Those filing single and head of household can contribute the maximum if they earn less than $122,000. Contribution amounts phase out for individuals making between $122,000 and $137,000, and go away completely for salaries over $137,000.

Traditional IRA

There are no income limits for traditional IRAs, but you must be 70.5 or younger to open an account. Investors choose to open a traditional IRA either because they make too much for a Roth IRA or because they want the tax benefit.

One of the biggest drawbacks to choosing a traditional IRA is taking required minimum withdrawals (RMDs). The RMD is based on your age, the age of your primary beneficiary, how much your balance is worth and if your spouse is your primary beneficiary.

Your brokerage firm can help you calculate the RMD amount so you don’t take out more than necessary. Some can set up RMD payments that are automatically deposited to your bank account. See our review of the best online brokers to find a firm that fits your needs.

Even if you’re still working or receive enough money through Social Security benefits, you have to take an RMD. Failure to do so results in a penalty, which will be 50% of the difference between what you withdrew and your RMD.

A Side-by-Side Comparison for 2019

Roth Traditional
Qualifications to contribute $203,000 or less for married couples; $137,000 or less for individuals None
Yearly contribution limitations $6,000 and an extra $1,000 for those 50 or older $6,000 and an extra $1,000 for those 50 or older
Withdrawal requirements None Retirees must withdraw money from a traditional IRA starting at age 70.5
Immediate tax benefits None Contributions are tax-deductible
Future tax benefits Withdrawals won’t be taxed in retirement None
Limits to withdrawals Withdraw contributions at any time; 10% penalty if you take withdrawals before 59.5 10% penalty if you take withdrawals before 59.5
Note: The penalty may be waived if you have a financial hardship, such as paying for college expenses or high medical bills or buying a new home.

Choosing a Roth IRA vs. Traditional IRA Doesn’t Need to be Complicated

Picking between a Roth or traditional IRA can seem intimidating, but it’s mostly a simple decision. A general rule of thumb is to choose a Roth IRA if you’re young, at the beginning of your career, or if you can afford to go without the tax deduction. Older folks or self-employed people might prefer a traditional IRA because they want the tax deduction to decrease their taxable income.

Here’s another easy way to think about it: do you think you’ll be in a higher tax bracket now or in retirement? If you think you’ll be paying fewer taxes in retirement, use a traditional IRA now to get the tax break. If you think you’ll be paying more taxes in retirement than you are now, use a Roth IRA.

There’s no way to accurately predict tax rates because the tax code can change every year. Choosing a Roth IRA now because you think your tax bracket will be higher in retirement is merely a guess based on the current tax laws.

Investors who truly can’t decide which one to use can open and contribute to both, but your total contributions must still be under the annual limit. For example, if you have a Roth and traditional IRA, you can contribute $3,000 to your Roth and $3,000 to your traditional for a total of $6,000. Married couples can have one spouse contribute to a Roth and the other contribute to a traditional.

If you want to make the best decision, consult a financial planner. They’ll be able to analyze your retirement account and tax situation to suggest an individualized strategy. They can also help you to adjust your investment strategy as your life circumstances change throughout the years.

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