IRA vs Mutual Fund Compared: Which Is a Better Investment?

IRA vs Mutual Fund Compared: Which Is a Better Investment?

If you’d like to compare an IRA with a mutual fund, you’re in the right place. Both of these are vehicles to store your money for long-term growth. But that’s where the similarities end.

In fact, it’s possible to invest in a mutual fund via an IRA. When you do this, you get the best (and worst) of both worlds. 

Below, we’ll explore the pros and cons of: 

  • investing money in an IRA; 
  • investing money in a mutual fund;
  • investing money in a mutual fund via an IRA. 

Read on to discover which is likely to be the best option for you. 

Main Differences Between IRA vs Mutual Fund

The main differences between IRA vs mutual fund are:

  • Mutual fund is an investment, whereas an IRA is a vehicle that can hold several different investments within it (including mutual funds).
  • Mutual fund has no special tax advantages, whereas an IRA does. In fact, you can potentially invest tax-free.
  • Mutual fund has no limits on how much you can invest per year, whereas an IRA does. 

How To Choose An Investment Vehicle

When choosing an investment platform, you ultimately want to choose the platform most likely to make your money grow quickly. There are several factors that will determine this, which we’ll explore below. 

How much tax will you pay?

With some investment vehicles, you’ll pay tax on your profits. With others, tax is waived. 

Can I choose how the money is invested?

Some investment vehicles (such as a basic savings account) will guarantee a flat interest rate, in which it doesn’t matter where the bank invests your money.

IRA vs Mutual Fund Compared

With other vehicles, your profits will depend on where your money is invested. The amount of input you get as far as where your money goes will depend on your choice of vehicle. Sometimes, you’ll only be able to choose from pre-determined investment portfolios, or pre-determined strategies such as ‘low-risk or ‘speculative’. Elsewhere, you can decide exactly where your money goes.  

What is investment risk?

Investment risk is the likelihood of your investment dropping in value. With some investment vehicles (such as basic savings accounts), there is no investment risk. With others (such as cryptocurrency), the risk is very volatile. 

Typically, with more risk, there comes a greater potential for higher profits.  If you have a managed portfolio of investments, you can instruct your manager on the level of risk you’re comfortable with. 

Are there any limits on deposits?

Is there a limit to the amount of money you can deposit, either in total or per tax year? If this limit is below the amount you’re looking to invest, you’ll need to find another vehicle for your renaming money.  

Are there limits on withdrawals?

Will you be able to withdraw funds instantly, or will you have to give notice? Some vehicles won’t let you withdraw money at all until the term is over. Others will let you withdraw early, but charge you a huge fee for doing so.

If you’re saving for retirement, this isn’t a big deal. But, if you feel like you might need the money for a rainy day, this needs to be considered.  

Are there any management fees?

If you have a fund manager tweaking your investments for you, you’ll likely pay a substantial monthly or annual fee for this.  

IRA Key Features

Here are the key aspects of an IRA that you need to understand before investing.

  • You’ll pay no tax on your profits
  • Whatever interest you earn is tax-free.
  • You choose what your money is invested in
  • You can choose to invest your IRA deposits into mutual funds, stocks, ETFs, bonds, and more. The level of choice you’re given depends on your IRA provider.
  • An IRA has annual deposit limits
  • These are determined by Congress for each tax year. For 2021-22, the annual limit is $6,000, or $7,000 if you’re over age 50.
  • Your employee has to match your IRA contributions
  • If your employer offers a company IRA, it will have to match your contributions. Free money!
  • You’ll face a huge fee if you withdraw before age 59 ½
  • You’ll face a 10% federal tax penalty if you withdraw funds before this age. 

Types of IRA

There are seven different types of IRA

IRA vs Mutual Fund Compared in details

There are seven different types of IRA, but it’s most important to understand the differences between a traditional IRA and a Roth IRA.

  • With a traditional IRA, you can deposit pre-tax or after-tax dollars. But when you withdraw, it’ll be taxed as earned income. You’ll face mandatory distributions at age 72.  
  • With a Roth IRA, you pay in after-tax dollars, but all withdrawals are tax-free. These are therefore more suitable for those who expect to be in a higher tax bracket when they withdraw. There are no mandatory distributions.

The thing is: A Roth IRA is only available to those below a certain income level. Again, this is decided by Congress each year. 

Now, you understand the basics, we can explore the remaining five types of IRA.   

  • SEP IRA. A traditional IRA is set up and paid for by your employer. The employer must match all employee contributions into this account. 
  • Non-deductible IRA. This is only really suitable for those who don’t qualify for a traditional deductible IRA or a Roth IRA.
  • Spousal IRA. Suitable only for low-earners or non-earners married to someone who has an income.
  • SIMPLE IRA. This is essential as SEP-IRA for small businesses and the self-employed, with a handful of different rules.
  • Self-directed IRA. This can be opened as a traditional or Roth IRA. It holds a greater range of investments, but there are more rules and risks. To be eligible, you’ll need to instruct a trustee or custodian who specializes in more complicated investments.    

Pros and cons

Pros

  • You’re given lots of flexibility as far as where you put your money. 
  • Tax benefits.
  • Employee contributions.

Cons

  • Annual limits on deposits.
  • Huge penalties for early withdrawals. 

Mutual Fund Key Features

A mutual fund is a company, which runs by buying shares in lots of other companies (or other securities).

When you invest in a mutual fund, you don’t own all the shares it owns, but you will get your fair share of the profits.  The idea is that you can access a diversified portfolio, which you otherwise might not have been able to afford.    

Here are the main things you need to know about this investment asset. 

  • There are no tax advantages or employee contributions…unless you invest in mutual funds via an IRA.
  • There are no deposit limits.

Invest as much as you like, whenever you like.

  • There are no withdrawal limits

You can cash out whenever you like, with almost no exceptions. The main exceptions are if you’ve invested in a ‘retirement account’ or if you’ve invested in Class B shares. 

You can choose what your money is invested in

If you choose an ‘active’ mutual fund, you can play a more active role as far as choosing where your money is invested. If you choose a ‘passive’ fund, a fund manager will make the big decisions for you.

Pros and cons 

Pros

  • You’re given lots of flexibility as far as where you put your money. 
  • No deposit limits.
  • No withdrawal limits (nearly always).

Cons

  • No tax benefits or employee contributions (unless investing via an IRA).
  • Not as much diversification is available compared to an IRA.

Recommended Alternatives

IRA vs Mutual Fund alternatives

  • 401k. A 401K is always offered by an employer, similarly to a SEP IRA or a SIMPLE IRA. Again, the employer might offer matching contributions up to a certain limit. There are fewer tax benefits with a 401k, but the annual deposit limits are far more generous. 
  • Individual securities. If you’re a confident enough investor, you can choose which securities to invest in without the need for a mutual fund. Diversification is key though. Investing in 20-30 securities is far less risky than investing in 2-3. There are no tax breaks or employee contributions available here though. 
  • Real estate. A lot of people choose real estate investment to fund their retirement instead of IRAs, 401ks, or mutual funds. It’s possible to make a lot of money from rental income and capital growth. However, there is a lot of work involved, it’s difficult to get fast liquidity and there’s no guarantee that your properties will all grow in value. Diversification is once again key when investing here. 

IRA vs Mutual Fund: The Bottom Line

When choosing between an IRA vs mutual fund, your decision will ultimately come down to whether you’re comfortable waiting until you’re 59 ½ years old to withdraw your funds. If that doesn’t work for you, an IRA won’t be your best investment. 

But, if you’re happy to wait that long, you should absolutely put your money into an IRA. You’ll get tax advantages and potential employer contributions by doing so. You could even put your money into a mutual fund via an IRA.

Remember, you can only deposit a certain amount per tax year into an IRA. So, if you have any leftovers, you can always put that into a non-IRA mutual fund.

Joe Elvin

Joe Elvin is an online writer who has specialized in personal finance since 2011, who has previously written useful advice guides for the likes of Finder and Which? Money. He's currently enjoying the digital nomad lifestyle, so you're most likely to find sipping coffee at some cafe in South East Asia.