Minimizing Expenses and Maximizing Returns with ETFs Inside a Roth IRA

by Kevin on April 30, 2013

Over the last few points we’ve been discussing whether or not ETFs make sense inside of a Roth IRA. We’ve discovered that if you trade often the trading commissions will eat you alive; you’d be much better off sending your money off to low expense ratio mutual funds.

Here’s what we’ve discussed thus far:

I don’t want to complete wipe out the idea of using ETFs there is one strategy that you can use.

The Best of Both Worlds: Lower Expenses Using ETFs Inside a Roth IRA

We’ve already shown that trading often with ETFs will wipe out the lower expenses you pay as part of your portfolio. You’re better off sticking to mutual funds if you want to do that.

However, you can use a strategy that includes using mutual funds for a few years to build up your portfolio then moving that part of your portfolio in bulk to ETFs.

Then you switch back to mutual funds and repeat in the future.

Here’s how it works as an example:

  • You contribute $5,500 per year into a Roth IRA
  • You use Vanguard’s Target Retirement 2050 Fund (Expense ratio: 0.18%) as your mutual fund
  • You use a mix of 3 different ETFs with a total expense ratio of 0.0845% when you switch to ETFs (the difference between the mutual fund portfolio and the ETF portfolio is 0.0955% in expenses)
  • You pay $7 per ETF trade

First you set up your automatic contributions to the Vanguard Target Retirement fund. Since I do my investing with Vanguard directly, I pay no trade commissions. You can set up your automatic contributions however you like: twice per week, once per week, once per month, whatever. As long as you contribute $5,500 by the end of the year (or technically by April of the following year) it doesn’t matter.

As your portfolio grows you’re paying the same 0.18% expense ratio on the portfolio. That’s $9.90 on $5,500 invested.

Then you just wait to have enough money in your portfolio that paying the three trade fees ($7 x 3 = $21) is made up in the drop in the expense ratio.

Make sense?

You want to pay the lower expense ratio and have the difference between the old, higher expense ratio and the new, lower expense ratio equal the $21 in trade fees.

It comes down to simple math.

Convert from mutual fund to ETFs = ($21 / 0.0955%)

Convert from mutual fund to ETFs = $21,989.53

At $21,989.53 you can sell the shares of the mutual fund equivalent to that amount, have three trades into the ETF portfolio at $7 each, and come out even during that year thanks to the lower expense ratio. Every year after that you will enjoy lower expenses on that section of your portfolio.

The point at which you should convert from mutual funds to ETFs depends on:

  • what mutual funds you are currently invested in
  • what those mutual funds charge for expense ratio
  • what, if any, cost you have to buy/sell shares in those mutual funds
  • what ETFs you would invest in instead
  • what the expense ratio is for those ETFs
  • what you pay for trade commissions to get into the ETFs

The above data is for my personal situation, with my preferred mutual fund investment, and what I would use ETFs to build a portfolio for. Use the above strategy to figure out what your break-even point to switch to ETFs is.

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