They're two different things, but the money you save in a retirement account can be invested in mutual funds. In fact, that's a good idea.

Investing and saving for retirement are filled with terms that can be confusing to the investor, and terms like these are often mistakenly used interchangeably. To clarify:

  • You may open a savings account such as a 401(k) or an individual retirement account in order to invest money regularly towards your retirement.
  • You have many options for how to invest your money, and mutual funds are usually among these options. In fact, most people who have such accounts invest all or a portion of their money in one or more of these funds.

Key Takeaways

  • Mutual funds are an investment option that is usually available to owners of retirement accounts.
  • You may choose one or more mutual funds and other investments for your IRA or 401(k) plan.
  • A retirement account may hold any type of investment, such as ETFs, stocks, bonds, commodities, or even real estate.

Understanding Mutual Funds

A mutual fund is a pool of money from many investors that is created by a financial services company. A fund manager selects the investments, which may be any combination of stocks, bonds, and other assets. The manager is responsible for maintaining the fund and adjusting its investments as needed.

An individual invests in a mutual fund in order to obtain the professional investment expertise and the sheer clout that a mutual fund offers.

There are thousands to choose from. An increasingly popular variety is the exchange-traded fund (ETF), which tracks a specific index. That means less hands-on management and lower management fees.

Investing in Mutual Funds

If you have a company-sponsored retirement account such as a 401(k) plan, you will choose how your money is invested from a number of options that the company offers.

These choices probably will include a range of mutual funds such as a bond fund suitable for a conservative investor and an international growth fund suitable for an investor who is willing to take on some risk. You'll probably have the option to split up your money into several different choices.

If you are self-employed or for any other reason don't have access to a 401(k), you can invest in an IRA. You can open one through just about any brokerage or other financial institution.

At that point, your options are wide open. There are thousands of mutual funds to choose from.

Other Savings

Mutual funds aren't just for retirement accounts.

If you want to save money for any purpose, investing in a mutual fund is a good option.

Tax Implications

Whatever you invest in, putting money into a 401(k) or IRA account saves you money on your taxes.

  • If it's a traditional 401(k) or IRA, the money you put in is considered pre-tax. It reduces your taxable income for the year. The taxes are owed only when you withdraw the money, presumably when you retire.
  • If it's a Roth IRA, the money you pay in is taxed in that year. You'll owe no further taxes when you withdraw it.

In any case, there are limits to how much you can invest in a retirement account each year.

These rules are only for long-term retirement savings accounts that are government-approved, as are 401(k) and IRA plans.

If you invest in a mutual fund or anything else outside that fund, there is no such tax advantage.

Why Mutual Funds

A mutual fund is subject to the same market whims as individual investments, but a mutual fund's inherent diversification makes it safer and less volatile. Investing in a fund gives you a tiny stake in many different assets.

Investing directly in mutual funds can be an effective way to save for retirement.

A sharp loss or even failure of a single company has far less impact on investors who are only exposed to it as part of a mutual fund, since their money is spread across dozens or hundreds of companies.

Mutual funds provide a diversified approach to investing that can track market indexes or sectors, such as healthcare, precious metals, energy, or technology.

Mutual Funds Made for Retirement Accounts

Some mutual funds function to meet the specific financial needs of people saving towards retirement. Retirement income funds are mutual funds that pair the protection of diversification (in such mixed holdings as bonds and large and mid-cap stocks) with the potential for moderate gains.

Vanguard's Target Retirement Income Fund, for example, is designed for investors who are already retired. It invests in five of the investment company's index funds, with 30% of the assets in stocks and 70% in bonds.

This and similar fund strategies can produce the safest route to a steady post-work income. They typically aim for returns of about 4%, the recommended size of annual withdrawals from retirement accounts.