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ETFs vs Index Funds in Tax Exempt Retirement Accounts?

While I understand the primary differences between an ETF vs an index fund (fund minimums are higher in index funds, pricing when buying/selling shares, fees/expenses) it seems like when dealing with a tax exempt account (a Roth IRA for example) the only major difference between the two is that with dividend distributions, an ETF would distribute that into a cash account in the Roth IRA while an index fund would simply reinvest those shares (presuming you have it set to reinvest) and thus, with a long term outlook, an index fund would be better since you're not paying commissions when you turn that cash into more shares in the ETF. Do I have that right? Any other major differences I should know? I know the expense % may be a bit lower with an ETF (I invest at Vanguard and am mostly in Admiral shares which don't have a much higher expense ratio compared to similar ETFs) but not materially to make me see the point in ETFs in a tax exempt account. I'm 33 w/ roughly ~$420k in retirement savings all in indexed funds @ Vanguard (across large-mid-small caps and value-blended-growth funds). I'm just trying to understand any unknown value in holding ETFs in my retirement accounts?

May 29, 2014 by Colin from Oak Creek, WI in  |  Flag
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3 votes
David Fabian Level 19

Colin - many brokerages now offer you the ability to reinvest fractional shares in an ETF from dividends that you receive. I know for a fact that Fidelity offers this service. You typically have to specify this in your account preferences, but it can be an excellent way to continue to reinvest in a long-term holding similar to a traditional index-based mutual fund.

I would check with Vanguard to see if they allow this type of reinvestment. They should not charge you any sort of trading commission either to purchase the fractional shares.

Comment   |  Flag   |  May 29, 2014 from Irvine, CA

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Colin: The advantages of ETFs are realized in 401k accounts that allow intra-day trading. ETFs trade on exchanges much the same way stocks do. An investor places buy or sell orders that are executed through a brokerage. This allows the investor to sell holdings in the case of a major market decline either by closely monitoring their portfolio during the day or through implementing stop or stop loss orders. Stop or stop loss orders are orders triggered when the market price of an ETF (or stock) reaches a pre-determined price. They are used to minimize potential losses while protecting gains. Mutual Funds on the other hand are bought and sold at the end of each trading day. If an investor wished to sell a position and placed their order early in the day it would not be completed until the end of the trading day at the closing price.

In the case of the Vanguard funds, their index ETFs are a share class of their index Mutual Funds. While the ETFs trade throughout the day, their underlying holdings are the same as their respective Mutual Fund. And as you mentioned expense ratios of ETFs and Mutual Funds are close if not the same.

The value added of ETFs vice index mutual funds is based on how actively you are able to mange your 401k portfolio.

Comment   |  Flag   |  May 29, 2014 from Sierra Vista, AZ

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Hello Colin,

That's a great question. Besides the issue of reinvesting of ETF dividends and the fractional share issue that others have covered, I think effectively the two types of vehicles, index mutual funds or index ETFs, should track closely, without material difference. Another major discount broker not mentioned by others also has a ETF reinvestment program, commission free. But you can only buy whole shares on a periodic basis when you have enough money available to purchase.

Comment   |  Flag   |  May 30, 2014 from Newport Beach, CA

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I think that once you are in a tax deferred environment, you need to consider total cost and return. Typically most ETF's provide low cost for investing especially in sectors and other asset classes vs. funds, some index funds are also very cost effective. Your overall strategy and risk management can be achieved in efficient markets. ETF's give you access to the less efficient markets like International and Small Cap at a very low cost vs. being able to do this through index funds. The index funds typically perform worse that a well diversified ETF in inefficient markets.

Comment   |  Flag   |  May 30, 2014 from Brighton, MI

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Richard K. Armon Level 10

Options are available on many ETF's. A clear advantage.

Comment   |  Flag   |  Jun 01, 2014 from Wayne, PA

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