Which Investments Are Best for Your Roth IRA?
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The best investments for your Roth IRA depend on your risk tolerance, time until retirement and goals.
Some assets are good options for the Roth IRA because of the way the IRS taxes investment income.
Stocks or ETFs that pay generous dividends could be a good candidate for your Roth IRA.
Stocks, bonds and mutual funds are all investments you may choose to hold in an IRA. But some subcategories of these assets may be better suited to a Roth IRA than a traditional IRA.
Why are certain assets more Roth-friendly? Short answer: because of the way the IRS taxes income. The less tax-efficient an investment is, the bigger the benefit of holding it in a Roth IRA.
What should I put in my Roth IRA?
That's up to you and your investment goals, but in general, consider holding in a Roth any investments that bring:
High growth potential, such as individual stocks that could dramatically rise in value.
Generous dividends, including real estate investment trusts (often called REITs) or other investments that pay regular streams of income.
High levels of turnover, such as actively managed mutual funds.
Frequent trading events, where investor activity triggers taxable events.
When do I get taxed?
With both traditional and Roth IRAs, investment growth is generally not taxed as long as the money remains in the account. It’s when investors start taking distributions from their portfolios in retirement that the differences in tax treatment become clear:
Withdrawals from a traditional IRA are taxed at the account holder’s income tax rate. At that point you’ll owe taxes on both the earnings (which have grown tax-deferred) and your original contributions (which you got a tax pass on when you funded the account and deducted those contributions from your income taxes).
The opposite of everything above is true for the Roth IRA. Savers get no upfront tax break; contributions are made with after-tax dollars. But your patience is rewarded when it’s time to take distributions: Withdrawals of both earnings (which have grown tax-free) and contributions from a Roth IRA are typically not taxed — remember, you settled your tax tab at the outset by funding the account with money the IRS already taxed.
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What are the best assets for a Roth IRA?
Consider investments that will benefit from the tax-free growth the Roth offers, including:
Small-cap stocks and mutual funds.
International stocks (particularly emerging market companies or funds that focus on holding these types of companies).
High-yield corporate bonds.
Let’s say an investor earmarks $5,500 to buy stocks with high growth potential in her Roth IRA. During the next 25 years, the companies thrive and generate an average annual return of 15% per year.
Her investments are now worth roughly $180,000. If she holds those stocks in a Roth IRA, that’s $180,000 she can withdraw from the account tax-free, regardless of what tax bracket she finds herself in during retirement.
This is why it’s wise to stash your most aggressive growers — investments with higher total return prospects — in a Roth IRA.
» MORE: Follow these simple steps to start investing in stocks.
On the flip side, putting investments such as money markets or certificates of deposit in a Roth doesn’t really pay off since these slow-growing investments earning low returns won’t amount to a huge tax burden down the road anyway.
» Ready to try a Roth IRA? Check out our list of best Roth IRA account providers.
What else should I consider?
Your tax owed on withdrawals isn’t the only reason to be aware of the implications of asset location.
The tax characteristics of the investments themselves is another factor to weigh. For example, an investment that generates interest income that’s already exempt from taxes doesn’t need the coverage the Roth offers. Dividends paid on municipal bonds, for example, are already exempt from federal taxes.
Dividends paid out by REITs, on the other hand, are not sheltered from the IRS’ reach. And because REITs are known for generous dividends, the Roth makes an ideal home for this type of investment.
Another consideration is the frequency of trading activity that takes place within the account — and within the investments held in the account.
In a regular, taxable account, investors who trade in and out of positions frequently expose themselves to short-term capital gains taxes. Short-term capital gains, which are profits on investments held for less than a year, are taxed at a higher rate than long-term capital gains.
For active traders, a Roth IRA is ideal: The IRS doesn’t even require you to report capital gains taxes each year. And, of course, qualified distributions in retirement are tax-free.
For the same reason, actively managed mutual funds with high turnover rates are well-suited to the Roth’s tax protections. (Side note: Passively managed funds — index mutual funds and ETFs, for example — have less internal buying and selling.)
Finally, consider your timeline when deciding whether to hold an investment in a Roth, traditional or taxable account. The longer you can let an investment ride, the higher the potential returns and number of tax dollars saved by avoiding an IRS bill when you eventually withdraw the money.
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