I'm currently investing in a low-cost index fund and wonder what's the point of opening an IRA (either Roth or traditional).

The big con of IRA is that you can't withdraw before retirement age without a penalty.

The pro is that you save on tax either when putting money in (traditional IRA), or taking money out (Roth IRA). In contrast, when investing in index fund, your available dollars to invest is already after income tax, and when taking money out you also have to pay capital gain tax.

So roughly speaking, for both IRA and index fund, I have to pay income tax at some point. But for IRA, I don't have to pay capital gain tax like index fund.

Is that basically it? Trading off between withdrawing-anytime vs paying-capital-gain-tax?

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    You could invest IRA monies in a low-cost index fund, so I'm not sure understand the question here? IRA is a type of account as is a taxable brokerage account. The index fund could be bought in either. Additionally, in a brokerage account there would be taxes on dividends and capital gains each year to consider that you don't state here.
    – JB King
    Commented Aug 20, 2014 at 21:00
  • @JBKing Is that right? I'm fundamentally misinformed then. So does it make sense to reframe my question as IRA vs taxable account? Is the trade-off as I mentioned?
    – Heisenberg
    Commented Aug 20, 2014 at 21:01
  • 4
    @Heisenberg: Right, an IRA is just an account type, whereas a mutual fund is something in the account. The choice of index funds vs other investments (e.g., individual stocks) is independent of the choice of IRA vs taxable account.
    – BrenBarn
    Commented Aug 20, 2014 at 21:19
  • 2
    It's worth noting that deferring when you pay income tax may have value in itself. If you're in a lower tax bracket in retirement than you are now it may well be a win to pay income tax later. Commented Aug 21, 2014 at 15:00

5 Answers 5


Is that basically it? Trading off between withdrawing-anytime vs paying-capital-gain-tax?

No. Another significant factor is dividends. In an IRA they incur no immediate tax and can be reinvested. This causes the account value to compound over the years. Historically, this compounding of dividends provides about half of the total return on investments.

In a non-IRA account you have to pay taxes each year on all dividends received, whether you reinvest them or not. So outside of an IRA you have a tax drag on both capital gains and dividends.


Here are the few scenarios that may be worth noting in terms of using different types of accounts:

  1. Traditional IRA. In this case, the monies would grow tax-deferred and all monies coming out will be taxed as ordinary income. Think of it as everything is in one big black box and the whole thing is coming out to be taxed.

  2. Roth IRA. In this case, you could withdraw the contributions anytime without penalty. (Source should one want it for further research.) Past 59.5, the withdrawals are tax-free in my understanding. Thus, one could access some monies earlier than retirement age if one considers all the contributions that are at least 5 years old.

  3. Taxable account. In this case, each year there will be distributions to pay taxes as well as anytime one sells shares as that will trigger capital gains. In this case, taxes are worth noting as depending on the index fund one may have various taxes to consider. For example, a bond index fund may have some interest that would be taxed that the IRA could shelter to some extent.

While index funds can be a low-cost option, in some cases there may be capital gains each year to keep up with the index. For example, small-cap indices and value indices would have stocks that may "outgrow" the index by either becoming mid-cap or large-cap in the case of small-cap or the value stock's valuation rises enough that it becomes a growth stock that is pulled out of the index. This is why some people may prefer to use tax-advantaged accounts for those funds that may not be as tax-efficient.

The Bogleheads have an article on various accounts that can also be useful as dg99's comment referenced.

Disclosure: I'm not an accountant or work for the IRS.

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    "Roth IRA. In this case, you could withdraw the contributions after 5 years without penalty." You can withdraw the contributions any time without tax or penalty.
    – user102008
    Commented Aug 21, 2014 at 4:24
  • @JBKing: Unfotunately, you are confused. You cite the definition of qualified distributions. But we are not talking about whether distributions are qualified or not. We are talking about whether there is a penalty or not, which is a different matter. (By the way, withdrawing contributions after 5 years but before age 59.5 is also generally non-qualified.)
    – user102008
    Commented Aug 21, 2014 at 4:54
  • @JBKing: You should probably respond to comments in comments. Anyway, it says "The portion of the distribution allocable to earnings may be subject to tax..." Contributions are not earnings. (Also, like I said, there's no difference between after 5 years and before 5 years if you're below 59.5 and don't qualify for an exception -- they're both non-qualified distributions.)
    – user102008
    Commented Aug 21, 2014 at 18:19
  • @user102008, happy now?
    – JB King
    Commented Aug 21, 2014 at 18:30

The advantage of an IRA (or 401k) is you get taxed effectively one time on your income, whereas you get taxed effectively multiple times on some of the money in a taxable account.

You have to consider it from the perspective of time value of money -- the concept that an amount of money now is the same value as a greater amount of money in the future. And in fact, if you put your money in an investment, the principal at the start can be considered the same value as the principal + earnings at the end.

  • With a deductible Traditional IRA, you don't pay income taxes in the year you earn it. The money is invested and grows, and you pay income tax once on the entire amount of money when you withdraw it.
  • With a Roth IRA, you pay income tax once on the entire amount of money in the year you earn it, and you don't pay taxes when you withdraw it.

In both Traditional and Roth IRA, you pay taxes on the entire value of money once (remember that the principal when depositing is the same value as the principal + earnings when withdrawing). The only difference is when (year deposited or year withdrawn), so the main difference between the two is the tax rate when depositing vs. tax rate when withdrawing.

  • With a taxable account, you pay income tax once on the entire amount of money in the year you earn it. And then you must also pay tax on any earnings later. Keep in mind that these earnings grew out of money that's already taxed, so the value of those earnings have already been taxed, and they're taxed again. You get taxed effectively multiple times on the portion of the money that's the earnings. That's the disadvantage of taxable accounts. It doesn't matter how low a tax rate you pay on those earnings, as long as it's more than 0, this is worse tax treatment than IRA/401k. (If you put it in a bank, where earnings get taxed every year, it's even worse; a certain part of the money gets taxed 2,3,4,...n times.)

I'll give you an example to demonstrate. We will assume you invest $1000 of pre-tax wages, it grows at 5% per year, there's a 25% flat tax now and in the future, you withdraw it after 20 years, and withdrawals are not subject to any penalty.

  • Deductible Traditional IRA: You start with $1000. It's not taxed initially. It grows for 20 years to $1000 * (1.05)^20 = $2653.30. It's taxed at 25%, so you are left with $2653.30 * 0.75 = $1989.97.
  • Roth IRA: You start with $1000. You pay 25% income tax, to leave $1000 * 0.75 = $750. It grows for 20 years to $750 * (1.05)^20 = $1989.97. Note that is the same as with the deductible Traditional IRA (it follows from associativity and commutativity of multiplication). If tax rates were lower at depositing than withdrawal, then Roth would be better; if tax rates were higher at depositing than withdrawal, then Traditional would be better.
  • Taxable account: You start with $1000. You pay 25% income tax, to leave $1000 * 0.75 = $750. It grows for 20 years to $750 * (1.05)^20 = $1989.97, for earnings of $1989.97 - $750 = $1239.97. You have to pay 25% tax on this or $1239.97 * 0.25 = $309.99. You are left with $1989.97 - $309.99 = $1679.98, substantially less than the IRAs. Even if you could qualify for a long-term capital gains tax rate of 15%, you would still pay $1239.97 * 0.15 = $186.00 in taxes, leaving $1989.97 - $186.00 = $1803.97.
  • There's another situation - the fact that a 15% marginal tax payer currently has a 0% Long term cap gain rate. And the pretax IRA will tax all withdrawals at your marginal rate (as would a 401(k). Commented Aug 22, 2014 at 23:00
  • "the fact that a 15% marginal tax payer currently has a 0% Long term cap gain rate" Right but that would still only make it just as good as, but not better than, IRA/401k. "And the pretax IRA will tax all withdrawals at your marginal rate" Yes, that is a consideration that makes Traditional slightly better than Roth. I avoided talking about tax brackets by saying "tax rate" which means "effective tax rate of the IRA/401k portion of the withdrawal". But of course that is affected by brackets, and Traditional will have an advantage because the withdrawal may dip down into lower brackets.
    – user102008
    Commented Aug 23, 2014 at 2:40
  • So why would anyone buy a mutual index fund than if you have to pay taxes on the investment and the dividends that it creates? Is it because you don't get penalized for pulling it out unlike the IRAs?
    – Donny V.
    Commented Dec 26, 2018 at 15:34
  • @DonnyV.: First of all, you can have index funds in an IRA. If you are asking about why invest in a taxable account vs. in an IRA, yes, an IRA should be better if you hold it until retirement. But 1) there are annual contribution limits to an IRA ($5500 for 2018), and there are income limits to deducting a Traditional IRA contribution and to contributing to a Roth IRA, so people are limited in how much they can put into an IRA, and yes, 2) there are various penalties and taxes for early withdrawals of IRAs (though there are no penalties or taxes for withdrawing the Roth IRA principal).
    – user102008
    Commented Dec 27, 2018 at 6:13

Whoa. These things are on two dimensions. It's like burger and fries, you can also have chicken sandwich and fries, or burger and onion rings.

You can invest in an taxable brokerage account and/or an IRA.

And then, within each of those...

You can buy index funds and/or anything else.

All 4 combinations are possible.

If someone says otherwise, take your money and run. They are a shady financial "advisor" who is ripping you off by steering you only into products where they get a commission. Those products are more expensive because the commission comes out of your end. Not to mention any names. E.J.

If you want financial advice that is honest, find a financial advisor who you pay for his advice, and who doesn't sell products at all. Or, just ask here.

But I would start by listening to Suze Orman, Dave Ramsey, whomever you prefer. And read John Bogle's book.

They can tell you all about the difference between money market, bonds, stocks, managed mutual funds (ripoff!) and index funds.

IRA accounts, Roth IRA accounts and taxable accounts are all brokerage accounts. Within them, you can buy any security you want, including index funds. The difference is taxation.

Suppose you earn $1000 and choose to invest it however Later you withdraw it and it has grown to $3000.

  • Investing in a taxable account, you pay normal income tax on the $1000. When you later withdraw the $3000, you pay a tax on $2000 of income. If you invested more than a year, it is taxed at a much lower "capital gains" tax rate.

  • With a traditional IRA account, you pay zero taxes on the initial $1000. Later, when you take the money out, you pay normal income tax on the full $3000. If you withdrew it before age 59-1/2, you also pay a 10% penalty ($300).

  • With a Roth IRA account, you pay normal income tax on the $1000. When you withdraw the $3000 later, you pay NOTHING in taxes. Provided you followed the rules.

You can invest in almost anything inside these accounts:

  • Money market funds. Terrible return. You won't keep up with the market.

  • Bonds. Low return but usually quite safe.

  • Individual stocks. Good luck.

  • Managed mutual funds. You're paying some genius stock picker to select high performing stocks. He has a huge staff of researchers and good social connections. He also charges you 1.5% per year overhead as an "expense ratio", which is a total loss to you. The fact is, he can usually pick stocks better than a monkey throwing darts. But he's not 1.5% better!

  • Index funds. These just shrug and buy every stock on the market. There's no huge staff or genius manager, just some intern making small adjustments every week. As such, the expense ratio is extremely small, like 0.1%.

If any of these investments pay dividends, you must pay taxes on them when they're issued, if you're not in an IRA account. This problem gets fixed in ETF's.

  • Index ETF's. These are index funds packaged to behave like stocks. Dividends increase your stock's value instead of being paid out to you, which simplifies your taxes. If you buy index funds outside of an IRA, use these.

  • Too many other options to get into here.


Lots of good answers. I'll try and improve by being more brief. For each option you will pay different taxes:

Index Fund:

  1. Income tax today on invested amount
  2. Capital gains tax at retirement

Traditional IRA

  1. Income tax at retirement on invested amount
  2. Income tax at retirement on capital gains

Roth IRA

  1. Income tax today on invested amount

You can see that the Roth IRA is obviously better than investing in a taxable account. It may not be as obvious that the traditional IRA is better as well. The reason is that in the traditional account you can earn returns on the money that otherwise would have gone to the government today. The government taxes that money at the end, but they don't take all of it.

In fact, for a given investment amount X and returns R, the decision of Roth vs Traditional depends only on your tax rate now vs at retirement because

X(1-tax)(1+R_1)(1+R_2)...(1+R_n) = X(1+R_1)(1+R_2)...(1+R_n)(1-tax)

The left hand side is what you will have at retirement if you do a Roth and the right hand side is what you will have at retirement if you do traditional. Only the tax rate differences between now and retirment matter here.

An index fund investment is like the left hand side but has some additional tax terms on your capital gains. It's clearly worse than either.

  • but the IRA or a Roth IRA can be invested in an index fund. Commented Aug 22, 2014 at 22:22
  • By "Index Fund" I mean here an index fund purchase through a taxable account. What you hold in the other accounts doesn't matter because you don't pay tax along the way. Could be an index fund or anything else. The index fund idea was just taken from the OP, who had the notion that an index fund in a taxable account is a substitute for a tax-advantaged account like an IRA. That idea is incorrect.
    – farnsy
    Commented Aug 23, 2014 at 6:05

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