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How to Choose Between a Mutual Fund and an ETF

Brian Preston, Bo Hanson

The investment world is constantly changing. Investing in the past primarily meant you worked with a broker to buy stocks and bonds, while your local banker would help with your cash holdings. But the way most investors handle money is now quite different.

As more people began to invest, the rise of diversification took hold and more investment options became available and cost-effective through the use of pooled investment accounts structured as mutual funds. In the 1970s, John Bogle was one of the first adopters of index investing, which allows many retirement investors to capture stock market gains at a lower cost.

[See: How to Reduce Your Tax Bill by Saving for Retirement.]

Another innovation in investing came with the introduction of exchange-traded funds in 1993. If you have joined the growing ranks of passive investors, then you have to make a choice between mutual funds and ETFs. Both of these investment options could help you to achieve financial success if you can leverage each of their benefits. Here's how to make the most of each type of investment.

Mutual Funds

Readily available. Mutual funds control the lion's share of the retirement marketplace. They are likely to be among the offerings in your employer-sponsored retirement plan, which makes them easy to invest in with money that is withheld from your paycheck. And if you hold mutual funds in a 401(k), you won't owe tax on any of the investment gains until you withdraw the money from the account.

Less frequently traded. Mutual fund shares trade only once per day after the markets close, and many people buy and hold them over the long term. So, they are less subject to market manipulation and trading inefficiencies.

Tax benefits. After recessions and bear markets, mutual funds have potential tax benefits such as tax-loss harvesting and carrying capital losses from prior years. These tax mitigation strategies might allow for some opportunities to minimize taxes.

How to avoid fees. Some mutual funds charge a variety of fees including purchase, trading and redemption fees. Look for no-load mutual funds and no transaction fee funds. It is easier to set up dollar-cost averaging strategies when you can buy and sell the mutual funds with no extra charges. Selecting funds with minimal fees makes it easier to buy in small increments like $100 all the way up to larger increments of $5,000.

[Read: How to Avoid 401(k) Fees and Penalties.]

Exchange-Traded Funds

Trading flexibility. ETFs offer the ability to trade throughout the day just like a stock. If your investment strategy requires the ability to trade daily, ETFs offer additional flexibility.

Daily disclosures. Many types of ETFs are required to disclose their holdings daily. So ETFs have a bit more transparency into what you actually own and how the composition of your holdings is changing.

Tax efficiency. Both mutual funds and ETFs are subject to capital gains taxes and taxes on dividend income. However, ETFs generally generate fewer taxable events while the fund is held, and ETF investors tend to receive fewer year-end capital gain distributions, which could result in a lower tax bill.

Your behavior and desired goals should be factored into which investment is a better fit for you. If you have long-term savings goals like retirement or a home down payment, then the dollar-cost averaging benefit of mutual funds is likely to appeal to you. If you are an active trader and desire the easiest platform to execute this strategy, you might lean towards ETFs. Also, make sure you understand how each option will affect your tax bill, and when it makes sense to hold each investment in a retirement account.

[See: 10 Ways to Make Your 401(k) Balance Grow Faster.]

Both of these investment vehicles can play an important part in an investment strategy that is suitable for your specific situation. It is important to understand how each of these investments works and the pros and cons associated with both. The path to financial success can be complex, but understanding your choices and options can help you navigate and make the best decisions for your family.

Brian Preston and Bo Hanson are fee-only financial planners who host the podcast, "The Money-Guy Show".

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