Both mutual funds and exchange-traded funds (ETFs) are extremely popular among the working generations and retirees, but knowing which product is right for you depends on a number of factors. To determine which product is best suited to your retirement needs, evaluate your specific investment goals, the type of investing strategy with which you are most comfortable, and the various costs and tax implications associated with both options.

What's Your Trading Strategy?

The most important factor when deciding between mutual funds and ETFs is your investment strategy. If you are most comfortable with a passive strategy – meaning you prefer to invest in a given product and then allow it to grow in value over time with little oversight – there are a number of options in both mutual funds and ETFs.

ETFs are primarily passive investments because the majority track a given index, seeking to match its returns. Many indexed mutual funds employ the same strategy. This means that the fund simply invests in all the stocks on a given index and trusts that the market will be generally bullish over time. There is little trading activity, except when the underlying index adds or removes a security.

If you are a more aggressive investor with a higher risk tolerance, a passive investment may not be able to generate the returns you want. If you want a product with a more active trading style – meaning the fund is managed by a professional who picks individual securities that he believes will outperform the market – then mutual funds offer a much broader range of options. The specific type of fund that will be best suited to you depends on your investment goals.

Know Your Goals

You investment strategy and goals are inherently intertwined. If you prefer a passive strategy, your goal is to generate steady growth over time, rather than quick gains or regular dividend income.

Active strategies can accomplish a broader range of goals because of the wide variety of products available. If your goal is to generate consistent investment income each year to supplement 401(k) distributions or pension payments, for example, dividend-bearing mutual funds can maximize your annual income by investing in only stocks with solid histories of paying generous dividends. For those looking to capitalize on market volatility to generate rapid gains, aggressive, high-yield mutual funds offer high-risk, high-reward options for any sector, industry or market.

There is a perception that a person planning for retirement exclusively employs a passive strategy because of its relative safety compared to active management. Most investments targeted at retirees highlight their safety and stability under the assumption that the elderly only want slow and steady – though modest – gains. However, depending on your investment goals, the amount you have to invest and the current contents of your portfolio, actively managed products that offer the potential for greater gains (at greater risk, of course) can be a proactive addition.

Understand the Tax Implications

When choosing between mutual funds and ETFs for your retirement, understanding the tax implications of both options is crucial to prudent decision-making. If you have a taxable investment account – meaning it is held outside of any tax-deferred retirement savings account – then the gains you earn from your investments impact your taxes in the year when they are earned. This can mean a huge difference between the tax impact of mutual funds versus ETFs.

For starters, mutual funds are required to distribute all net gains, including any dividend or interest income, to shareholders at least once a year, automatically increasing your taxable income for the year. Those earnings may be taxed as ordinary income or as long-term capital gains, depending on the duration of your investment and the turnover ratio of the fund, but your tax burden increases either way. Actively managed funds, in particular, tend to have much higher turnover ratios, increasing the likelihood that your gains will be taxed at your highest rate. Even passively managed mutual funds, despite their lower turnover, often make taxable capital gains distributions because of inefficiencies in the share redemption process.

ETFs, conversely, typically make very few capital gains distributions because of their passive management and market-based trading and in-kind redemption processes. This makes them traditional more tax-efficient investments.

However, if you are still working and contributing to an employer-sponsored retirement savings plan, such as a 401(k), or your own traditional or Roth individual retirement account (IRA), the tax implications of your investments can be dramatically different. Though many retirement savings vehicles do not allow for investment in ETFs, any assets held in these accounts accrue earnings that are not taxed until their withdrawal. In the case of 401(k) or traditional IRA investments, earnings are taxed as ordinary income regardless of the duration of the investment. Roth IRAs, however, generate earnings that are tax-free, making them ideal vehicles for investments that make regular distributions.

When ETFs Are Right For You

If you are looking for an easy set-it-and-forget-it investment, ETFs can be an excellent way to put your money to work with minimal effort and with a relatively low tax impact. Because of their lower expenses and lack of load or 12b-1 fees, ETFs are much cheaper than mutual funds if you intend to make one large investment and hold it for a longer period. If you intend to manage your investment actively, by buying shares in smaller increments over time or trading your shares frequently, the commission charges on ETF trades can eat into your profits.

If you are investing in a taxable account, ETFs can be the more tax-efficient choice because of the reduced number of capital gains distributions.

When To Choose Mutual Funds Instead

If you want the option of investing in a more proactive product that seeks to beat the market rather than mirror it, mutual funds offer a range of options for any investment goal. Even if you opt for a more passive strategy, indexed mutual funds can be preferable if you want to grow your investment gradually over time. For example, if you plan to invest a few hundred dollars a month, mutual funds end up being cheaper in the long run despite their higher expense ratios.

If you are investing using retirement funds in a 401(k), IRA or another retirement account, the current tax liability of mutual fund income can be deferred or even negated if you have a Roth account. If mutual funds are a better fit for your investment strategy and goals, using Roth funds is the best way to maximize profits.

Why Not Use Both?

Of course, you can certainly utilize both products to maximize your retirement savings or supplement your retirement income. Both products have numerous advantages and can serve very different purposes. Mix and match investments to create a portfolio that provides a safe and secure source of modest income and offers the potential for substantial growth creation.