If you’re saving for retirement in a Roth IRA, index funds and actively managed mutual funds are two of your investment options. Both help diversify your portfolio, but they have different investment objectives, management styles, and—especially—costs.
Key Takeaways
- You can hold a variety of investments in your Roth IRA, including actively managed mutual funds and index funds.
- Index funds track specific indexes and tend to be cheaper than actively managed mutual funds.
- Even seemingly small differences in fees since can have a big impact on your retirement savings over time.
Roth IRA Investment Options
One of the benefits of a Roth IRA, as with a traditional IRA, is the wide 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 offered by the plan, you can invest in everything from individual stocks to real estate in a Roth. Two popular investments are actively managed mutual funds and index funds.
Investment Objectives for Managed Mutual Funds and Index Funds
Both actively managed mutual funds and index funds are made up of portfolios of securities, which might include stocks, bonds, or some combination of the two. But their objectives can differ.
Managed mutual funds seek to beat the returns of a related benchmark index. 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 stocks 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 corporate 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 index goes up or down, so does an index fund that tracks it.
Management Styles for Managed Mutual Funds and Index Funds
The key difference between these two types of funds is how they are managed. Actively managed mutual funds, as the name indicates, 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.
By contrast, index funds are passively managed. The investments are automated to track the underlying index, so they don’t require as much buying and selling. Because nobody actively manages the holdings, their performance is based solely on the price movements of the securities in the index.
Comparing Costs of Managed Mutual Funds and Index Funds
The fees you pay each year to own a particular mutual fund are known as the fund’s expense ratio. It measures how much a fund spends on management and other costs, expressed as a percentage of its total assets.
You’ll typically pay more for an actively managed mutual fund because the team running the show has to be paid and its more frequent trading will also rack up costs. The average expense ratio for an actively managed mutual fund in 2020 was 0.71%, but it can be lower or higher. In general, the expense ratios on managed mutual funds have been declining in recent years, due in part to competition from index funds.
Index funds have expense ratios, too. But since these funds aren’t actively managed, their costs tend to be much lower. The average expense ratio for an index fund in 2020 was 0.06%.
Even though the average fees for the two types of funds differ by less than 1%, that difference can have a huge impact on your Roth IRA balance over time. Suppose you invest $6,000 (the maximum Roth IRA contribution in 2022 for anyone under age 50) in a mutual fund that earns 8% a year and has a 1% expense ratio. After 40 years, your investment would be worth $87,199.
But what if you invested 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—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.
Managed Mutual Fund or Index Fund for Your Roth IRA?
Here’s a quick comparison chart of actively managed mutual funds and index funds.
What Is the Roth IRA Contribution Limit for 2022?
For 2022, the contribution limit for a Roth IRA account is $6,000. If you are 50 or older you can make an additional catch-up contribution of $1,000, for a total of $7,000. Note that if your income is over a certain level, you may only be eligible for a reduced Roth IRA contribution or none at all.
Can You Lose Money in an Index Fund?
Technically, yes, you can lose money in an index fund. However, it is unlikely in the long run. Index funds are extremely diversified. A stock index fund, for example, will hold many different stocks since its objective is to mirror a benchmark index that may consist of hundreds or even thousands of stocks. So even if some stocks in the fund lose value, it is unlikely that all or the majority of them will, particularly since most indexes are crafted with well-known companies.
Do I Need a Roth IRA to Invest in Index Funds?
No, you do not need a Roth IRA to invest in index funds. You can also invest in index funds through a traditional IRA or a defined-contribution plan, such as a 401(k). You can invest in them outside of a retirement account, as well.
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 overall. On average, expense ratios for managed mutual funds have declined substantially for more than 20 years, according to the Investment Company Institute, a trade group. Who knows what will happen in the next 10 or 20 years?