Comparing IRAs to mutual funds is a bit like comparing apples to oranges. An IRA is an account that can hold a variety of investments, everything from cash to stocks to mutual funds. A mutual fund is a specific investment, comprised of a series of holdings. Mutual funds collect money from investors to create and maintain a portfolio. While distinct products, you can still evaluate IRAs and mutual funds alongside one another.
You follow the same general process to open an IRA and a mutual fund. Fill out an application on or offline and submit it or send it in. The firm you decide to go with opens up your account. With an IRA, you have nothing but your initial cash contribution sitting in an account -- likely a money market fund -- until you decide how to invest it. IRA investment options are virtually limitless; you can invest in stocks, bonds, mutual funds, commodities, certificates of deposit, you name it. With a mutual fund, the firm immediately invests your contribution in shares of the mutual fund.
Most investors hold one of two types of IRA accounts -- a Roth or traditional IRA. Congress intended IRAs as retirement savings vehicles, however, you can use them for other purposes. Both types provide tax benefits. Mutual funds not held inside an IRA do not provide evident tax perks. There are literally thousands types of mutual funds. Some are quite straightforward, looking to mimic the returns of indexes such as the Dow Jones Industrial Average and the S&P 500. Others focus on niches, such as certain regions of the world -- Japan, the rest of Asia, the United States, Canada -- or sectors of the economy like telecommunications, technology or consumer products.
People, correctly, tend to best know IRAs for their tax benefits. As IRS Publication 590 details, you can deduct traditional IRA contributions from your taxable income, regardless of what you invest those contributions in. While you cannot deduct Roth contributions, they also come out tax- and penalty-free. If you wait until you are age 59 1/2 and have held your Roth account for at least five years, you can withdraw all Roth proceeds, including earnings, tax- and penalty-free. The IRS always taxes traditional IRA withdrawals, regardless of age and circumstance.
Mutual funds, unless held in an IRA, do not provide these tax benefits. In fact, they usually trigger taxable events. If you sell mutual fund shares, you must report any capital gains to the IRS and pay taxes on them. When the fund sells shares of holdings it owns or receives a dividend from a stock it owns, it pays out a distributions to its shareholders. You must report these distributions and pay taxes on them. When you hold a mutual fund in an IRA, these types of earnings grow on a tax-deferred basis, meaning you don't pay taxes on them every year. Depending on the type of IRA you have and how and when you access the proceeds, you may never have to pay taxes on them or you can at least wait until you take a distribution.
As noted, the federal government created IRAs as a way for Americans to save for retirement. You can also access IRA money early, without penalty, and in some cases with favorable tax treatment, for several purposes, such as covering costs associated with higher education or the purchase, building or rebuilding of a first home for yourself, your spouse, your children or your grandchildren. Of course, you can do all of the same things with individual mutual fund money not held in an IRA account. You receive no special benefits in the process, however. When you sell mutual fund shares, you pay taxes and, as noted, your earnings did not grow annually on a tax-deferred basis.
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