How to Invest in Mutual Funds: A Complete Guide for Beginners

A mutual fund pools money from many investors and uses that money to buy a range of securities including stocks, bonds and other assets. Mutual funds are typically managed by a professional fund manager that buys and sells securities in line with the goals of the mutual fund.

The goal of a mutual fund is to outperform the standard return of the stock market. This is why a professional fund manager tries to buy, sell and hold investments that will increase the likelihood that that will happen.

The first step to investing in mutual funds is to open an investing account. Your investing account will simply hold your mutual funds and other investments. If you contribute to a 401(k) plan at work, chances are you are already investing in mutual funds. However, there are a few other account types that you can consider holding mutual funds in.

Option 1 - Brokerage account: A brokerage account is the simplest investing account that allows you to buy and sell a range of assets including stocks, bonds, investment funds, and more. The primary advantage to placing mutual funds in a brokerage account is flexibility.

There are no limitations on who can have a brokerage account and no limitations on how much you can contribute to the account. You can also access the investments in your brokerage account whenever you need to. In other words, you can buy and sell the investments within your brokerage account whenever you need to.

The downside to holding mutual funds in your brokerage account is that you are subject to short or long term capital gains tax when you sell your mutual fund shares for a profit. If you held mutual fund shares in a brokerage account for less than a year and sold those shares for a profit, you would pay the same tax rate as you would pay on ordinary income - such as income from your job.

If you held mutual fund shares in a brokerage account for more than a year and sold them for a profit, you would pay 0 percent, 15 percent, or 20 percent capital gains tax depending upon your income. If you decide to hold your mutual funds in a brokerage account, it is better to hold the funds for at least a year before you sell in order to get a more favorable tax rate.

You can also incur additional taxes for holding a mutual fund within a brokerage account - not just when you sell shares of the mutual fund. If the fund earns dividends or income from investments like stocks and bonds, the mutual fund will distribute your share of those payments to you and you will owe taxes on that income.

Secondly, if the fund manager sells some of the investments within the fund for a profit, it will trigger a capital gains tax. Even though you did not sell shares of the mutual fund, you will have to pay tax from the investments that were sold for a profit within the mutual fund. You can avoid these tax problems by looking at Option 2 below.

Option 2 - Roth IRA: An IRA, or individual retirement account, is a tax advantaged investing account specifically designed to help you save for retirement. The Roth IRA is one of the most popular types of individual retirement accounts and works like this.

You make contributions to a Roth IRA with dollars that have already been taxed. However, when you take money out of a Roth IRA when you retire, you don't pay any taxes. Additionally, you won't have to pay taxes on dividends and income from your mutual funds that you would have to pay if you held them in a brokerage account.

If you are a long term investor, or are looking to save for your retirement holding mutual funds in a Roth IRA can be very beneficial thanks to the tax advantages of the account.

Since the Roth IRA offers tax benefits, the IRS does put some restrictions on the account. First, your income must be below a certain level to open a Roth IRA. If you file your taxes as an individual, your income has to be $138,000 or less if you want to make the full contribution. If your tax filing status is married filing jointly, your income has to be $218,000 or less if you want to make the full contribution. (Rules for 2022-2023).

Secondly, there are limitations on how much you can contribute to a Roth IRA. You can only contribute $6,500 per year, or $7,500 if you are 50 or older. You can start withdrawing money from your Roth IRA once you are 59 and a half, and have held the account for at least 5 years.

If you try to make an early withdrawal, you can incur a 10% penalty and be subject to pay additional income taxes. The exception to this rule is that you can withdraw the base amounts that you have made to a Roth IRA without incurring a penalty since you have already paid taxes on those dollars. However, you can't make easly withdrawals of any of the profits that you have made from your investments within your Roth IRA.

Related - How Do I Set Up a Roth IRA?

Which one of these accounts should you have?

It can be beneficial to hold mutual funds in a Roth IRA if you qualfiy. It will allow your mutual funds to compound and grow tax free, and then you don't have to pay taxes when you pull the money out of the account in retirement. The good news is that you can have both a brokerage account and a Roth IRA at the same time.

If you are able to keep investing in mutual funds after you have funded a Roth IRA, you can open a brokerage account as well. Keep in mind that if you hold mutual funds in a brokerage account, you can be subject to additional taxes. There is a way to minimize this however, which we will get to in Step 3.

Where can you open these accounts?

You can open both of these account types at almost all online brokers. The process for opening these accounts if pretty straightforward. Simply go to the website of your chosen broker and click on the option to open an account.

Select to open either a brokerage account or Roth IRA depending upon what you want. From there, you can fill out an application. Expect to have to provide information such as your name, address, contact information, income, social security number, and government ID.

There are a wide variety of mutual funds that you could invest in. It is a good idea to understand some of the most common types. With that being said, don't get to bogged down on which mutual fund type you should invest in. We will look at later.

1) Equity funds: Equity funds are also known as stock funds as these types of mutual funds invest in US or foreign stocks. Equity funds typically invest in stocks using one of three strategies: the market cap or size of companies (small-cap, mid-cap, large-cap), a specific sector of stocks (tech, healthcare, energy, etc.), and companies based upon their growth stage.

2) Fixed income funds: Fixed income funds invest in debt assets like bonds, and government securities. As the name implies, fixed income funds pay a fixed rate of return and allow your investment portfolio the chance to earn income.

3) Asset allocation funds: Asset allocation funds will invest in both fixed income assets (bonds) and equities (stocks). The split of bonds and stocks that are held within these types of funds will vary based upon the goal of the fun. These funds can provide both growth and income opportunites within one fund.

4) Index funds: Index funds hold the assets of an underlying index that the fund is tracking. For example, the S&P 500 is an index that tracks the performance of the top 500 companies in the US. If you bought an S&P 500 index fund, you would be buying the stocks of the top 500 companies in the US.

5) Target date funds: A target date fund is a type of asset allocation fund in which the mix of stocks and bonds changes over time as you approach the date that you will need the money. Target date funds usually have a year in which they are designed to mature, which are often in alignment with goals such as retirement and college savings.

6) Money market funds: Money market funds invest in cash equivalents such as US Treasury bills and CDs. They don't provide the returns of other types of mutual funds, but are often considered to be a safer option.

7) Commodity funds: Commodity funds allow investors to gain exposure to raw material investments. Think of things like precious metals, agricultural goods, and natural resources. Commodity funds invest in companies that are involved in these raw material operations.

Which of these fund types should you focus on?

Most investors typically don't start with fixed income funds, money market funds, or commodity funds and chances are you already are investing in target date funds if you contribute to a 401(k) plan at work. So, this leaves equity funds, asset allocation funds, and index funds.

We would recommend starting with equity or index funds. There are a couple of reasons for this. First, equity and index funds will allow you the potential to earn a higher return when compared to other types of funds since you are only investing in stocks. Second, both of these fund types are common and easy to invest in.

Now that you have an understanding of the type of mutual funds available, you can begin researching specific funds to invest in. The exact mutual fund(s) that are right for you will ultimately come down to your individual needs and investing goals. However, there are some things that you can look for as you are conducting your research.

1) Expense ratios: An expense ratio is simply a fee that a mutual fund charges to pay fund managers, and cover administrative and operational expenses. An expense ratio is charged as a percentage based fee. Mutual funds tend to average a 0.47% expense ratio. This means you would pay a $0.47 annual fee on every $100 you had invested in the fund.

As a general rule, you don't want to invest in mutual funds that have a higher expense ratio than 1% or 1.25%. With that being said, you can justify paying a higher expense ratio for some mutual funds if the fund performs well enough to cover the cost of the higher fee.

2) Load fees: In addition to expense ratios, some mutual funds also charge load fees. A load fee is a commission fee that you have to pay every time you buy or sell shares of the mutual fund. It is good to check if the mutual fund(s) you are interested charge this so you can be prepared to pay the fee, or not buy into the fund.

3) Minimum investment: Mutual funds may also require a minimum investment when you first buy into the fund. This typically starts around $500, but can go higher than that. However, there are some mutual funds that have low minimum investment requirements, or don't require one at all.

4) Turnover ratio: A turnover ratio is the percent of assets that a mutual fund sold or changed within the past 12 months. For example, a mutual fund that has a turnover ratio of 20%, sold or changed 20% of the total investments within the fund over the past 12 months. You might be asking yourself why a turnover ratio is important? One word: taxes.

Remember, if a mutual fund earns dividends or income, or sells assets for a profits, taxes are going to be paid. A mutual fund will pass on your share of dividends, income, and profit. You will then be required to pay taxes.

Keep in mind that this only matters if you hold your mutual funds in a brokerage account. If you hold them in a Roth IRA, you don't have to worry about the turnover ratio of a mutual fund as you won't be subject to pay taxes on gains.

However if you do plan to hold mutual funds in a brokerage account, you should pay attention to the turnover ratio of mutual funds that you are looking for. In general, you want to have a turnover ratio of 10% or less. This means that the mutual fund does not sell assets for profit as often, which means you won't have to pay as many taxes.

5) Performance: Finally, you want to look at the performance of a mutual fund. It is a good idea to look at mutual funds that average a return of 10% or more. You also want to look at funds that are well established and have performed well over time.

Look for funds with a 10 year track record. Keep in mind that mutual funds are not going to perform well ever year as the assets held within the fund can go up or down in value. However, what you are looking for is funds that recover from these downturns and keep performing well over time.

Where can you research mutual funds at?

The easiest place to research mutual funds would be through the online broker that you opened your investing account through back in Step 1. Almost all reputable brokers offer free research tools to help you find good mutual funds. On the website of your chosen broker, there is typically a research tab.

Click on this tab to be taken to the free research tools. From there, you should be able to filter out results to see the mutual funds you want. You can use the 5 items we talked about above as your filters to get started. If you don't like the research offered by your broker, there are third party research providers such as Morningstar that you can look into.

Once you have researched and picked a few mutual funds that you want to invest in, you can buy shares of those mutual funds. The first step to doing this is to transfer money from your bank account to your investing account - whether that be a brokerage account or Roth IRA. You can do this directly through the website of your online broker.

After your funds are in your investing account, you can search for the mutual fund(s) that you want to buy through the website or platform of your online broker. Once you pull up the fund that you want to invest in, simply enter the number of shares that you want and click the buy button. It's that simple.

1) The T. Rowe Price US Equity Research Fund (PRCOX): This mutual fund primarily invests in large-cap US stocks, but may also invest in small-cap, mid-cap, and foreign stocks as well. The fund has a reasonable expense ratio of 0.45% and has averaged a return of 12.71% over the past 15 years according to Morningstar.

2) The Massachusetts Investors Growth Stock Fund (MIGNX): This mutual fund looks to invest in strong, quality large-cap companies using a patient, valuation conscious method. The fund has a reasonable expense ratio of 0.37% and has averaged a return of 13.43% over the past 10 years according to Morningstar.

3) The BlackRock Exchange Blackrock Fund (STSEX): This mutual fund has a goal of long term growth and aims to achieve this by investing in strong large and mid-cap stocks. However, the fund may invest in companies with any market cap. The fund has an expense ratio of 0.77% and has averaged a return of 11.32% over the past 10 years according to Morningstar.

4) The State Street US Core Equity Fund (SSAQX): This mutual fund has a goal of long term growth and aims to achieve this by investing at least 80% of the fund in the stocks of strong US companies. The fund has a low expense ratio of 0.16% and has averaged a return of 12.12% over the past 10 years according to Morningstar.

Important note: Keep in mind that these mutual funds are only examples of what you could invest in and should not be taken as strict financial advice. The mutual funds that are right for you could be different. We recommend speaking with a licensed financial advisor if you need help choosing mutual funds.

Instant diversification: Since mutual funds hold dozens or hundreds of stocks, you will be less exposed to investing risk. If one of the stocks in a mutual fund is not doing well, the other stocks that the fund holds can make up for it.

Potential to beat market returns: Since mutual funds are professionally managed, there is the possibility for you to earn higher than average returns. The stock market historically averages a 10% return over long stretches of time, but some mutual funds can beat this average return thanks to good management.

Easy to invest in: Not only are mutual funds easy to invest in on a practical level, but they also eliminate the need to research your own investments. Instead you can buy good mutual funds and feel confident that the funds will perform well over long stretches of time.

Affordable: When you consider that you get an entire basket of stocks all at once, mutual funds are a very affordable way to invest. The expense ratios of most mutual funds hover around 0.47% per year, but can be less than that.

Potential to underperform the market: Although mutual funds can outperform the market, they can also underperfom it as well. Since mutual funds typically have higher fees than passively managed funds, such as index funds, a mutual fund that underperfoms the market over time can end up being a bad investment.

Tax implications: If you hold mutual funds in a taxable account, such as a brokerage account, you may have to pay taxes from assets the fund sells, as well as income from dividends. This is why it is important to invest in mutual funds that have a low turnover ratio if you hold mutual funds in a brokerage account.

The bottom line is that mututal funds can be a great investment option. You can invest in them by opening an investing account, understanding the types of mutual funds, researching mutual funds, and then buying shares of your chosen mutual fund. If you want more of a big picture on investing, you can check out our guide on how to start investing as a beginner.