Mutual Funds vs. ETF for Roth IRA?

Many retirement investors prefer Roth IRAs to traditional IRAs. Many financial professionals agree: They argue that these retirement accounts carry lower long-term tax burdens and permit investors to withdraw more of their hard-earned funds upon reaching retirement. Unfortunately, there's less agreement among financial professionals and retail investors on which investment classes provide the greatest rates of return in these particular accounts.

For many investors, this disagreement comes down to an argument over the merits of mutual funds and exchange-traded funds. Also known as ETFs, exchange-traded funds are managed funds that resemble stocks in a few key ways.

First, they trade on national financial exchanges like the New York Stock Exchange and NASDAQ. Unlike mutual funds, which must be purchased through a financial services firm, ETFs are highly liquid instruments. Since they trade on the open market, ETFs also carry lower expense ratios than most mutual funds. Some may pay dividends while others promise tantalizing rates of appreciation.

Whereas most mutual funds are little more than baskets of carefully-chosen stocks, many ETFs are fairly esoteric. The performance of some ETFs is conditioned upon specific market movements. In general, this produces wild volatility that may disturb some conservative retirement investors. Many ETFs are designed to magnify the performance of certain baskets of stocks, bonds or other financial instruments. Unfortunately, many lack hedging mechanisms to pare gains and limit losses. Depending upon market conditions, this can lead to huge gains as well as huge losses.

By contrast, mutual funds tend to be structured conservatively. This encourages long-term investors to buy and hold these products and tends to promote steady growth. Few mutual funds deliver annual growth rates above 10 percent for more than a year or two at a time. However, it's rare for a mutual fund to lose value in consecutive years.

When owned outside of either a traditional or Roth IRA, mutual funds may create some tax headaches. Since they're actively managed, these funds can buy and sell equities at a rapid pace. Each of these transactions has tax implications for fund owners. However, the tax-preferred status of an IRA negates most of these tax issues. As such, individuals who own mutual funds in tax-preferred accounts enjoy significant financial advantages. On the other hand, ETFs owned in traditional brokerage accounts produce "tax events" only when the instruments themselves are bought and sold. Accordingly, adding these instruments to retirement accounts produces fewer tax advantages.

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