If you're saving for retirement in a Roth IRA, index funds and mutual funds are two of your investment options. Both help diversify your portfolio, but they have very different investment objectives, management styles, and costs.

Key Takeaways

  • You can hold a variety of investments in your Roth IRA, including mutual funds and index funds.
  • Index funds track specific indexes and tend to be cheaper than actively managed mutual funds.
  • Watch out for fees since they can have a big impact on your retirement savings over time.

One of the benefits of a Roth IRA is the variety of investments you can hold in the account. While your investment options for employer-sponsored plans like 401(k)s are limited to those included in the plan, you can invest in everything from individual stocks to real estate in a Roth. Two popular investments are mutual funds and index funds.

Investment Objectives for Mutual Funds and Index Funds

Both mutual funds and index funds are made up of portfolios of stocks, bonds, short-term debt, and other securities. But their goals differ.

Mutual funds seek to beat the returns of a related benchmark index, after fees. They are managed based on a specific investment objective. For example:

  • Growth funds seek capital appreciation. These funds put a large percentage of assets into stocks because they offer higher potential rewards. As such, they tend to be riskier.
  • Income funds try to provide investors with a stable income. They invest in lower-risk investments such as bonds, government securities, and certificates of deposit (CDs).

An index fund, on the other hand, is a type of mutual fund that attempts to match a specific market index, such as the S&P 500 or the Russell 2000 Index. It follows its benchmark index no matter what the market is doing. When the S&P 500 fluctuates, so does an index fund that tracks it.

Management Styles for Mutual Funds and Index Funds

One of the key differences between mutual funds and index funds is their management style. Mutual funds are actively managed. That means there's a team of investment professionals who make the decisions. They actively pick the fund's holdings and adjust them as needed—often on a daily, or even hourly, basis.

Conversely, index funds are passively managed. The investments are automated to track the underlying index, so they don't require active buying and selling. Because nobody actively manages the holdings, the performance is based solely on the price movements of the securities in the index.

Comparing Costs for Mutual Funds and Index Funds

Of course, the different management styles mean different costs for mutual funds and index funds. The fees are known as the fund's expense ratio.

In general, you'll pay more for an actively managed mutual fund because the team running the show has to make money. It also has to pay to market the fund to attract more investors. The average mutual fund expense ratio is about 1%, but it can be lower or higher.

Index funds cost less than mutual funds in terms of expense ratios, but that gap is closing.

Index funds have expense ratios, too. But since these funds aren't actively managed, they tend to be much more affordable. On average, you'll pay about 0.05% to 0.07% for an index fund.

Even though the average fees differ by less than 1%, that difference can have a huge impact on your Roth IRA balance. Suppose you invest $6,000 (the maximum Roth IRA contribution for 2020) in a mutual fund that earns 8% and has a 1% expense ratio. After 40 years, your investment would be worth $87,199.

But what if you invest the same amount of money in an index fund with a 0.05% expense ratio? Assuming the same 8% return, your investment would be worth $130,347 after 40 years. That's a $43,148 difference. And that's just with one year's worth of Roth IRA contributions.

And something else to keep in mind. If you invest in an actively managed fund at 1% while a comparable index fund charges 0.05%, the fund managers have to beat the market by at least 0.95% every year to make up for that added expense. It’s possible for an active fund to have an amazing run that beats an index over several years. But historically, those funds have always come back down to Earth.

Mutual Fund or Index Fund for Your Roth IRA?

Here’s a quick rundown of mutual funds and index funds.

Mutual Funds vs. Index Funds
Feature Mutual Funds Index Funds
Investment goals Beat the returns of a benchmark index Match the return of a benchmark index
Management style Active; fund managers choose the holdings Passive; investments are automated to match the holding of the benchmark index
Invests in Stocks, bonds, and other securities Stocks, bonds, and other securities
Expense ratios Average is about 1% Average is about 0.2%

The Bottom Line

For now, index funds are the clear winner for Roth IRAs because of their low fees. However, as investors shift toward lower-cost funds, industry competition is driving down mutual fund expense ratios.

On average, expense ratios for long-term mutual funds have declined substantially for more than 20 years, according to a report from the Investment Company Institute. Who knows what will happen in the next 10 or 20 years?

Choosing investments for your Roth IRA is not easy. Both mutual funds and index funds are convenient options with the potential for growth. When in doubt, consult with a trusted financial advisor for help picking the Roth IRA investments that best fit your risk tolerance, investment horizon, and retirement goals.