Best Roth IRA Investments

Wondering what to invest in a Roth IRA — or even why it matters? 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 compared to a traditional IRA.

Stocks, bonds and mutual funds are all Roth IRA investment options you can have in your account. To make the most of your investment, here's how to choose investments for your Roth IRA.

What should I invest my Roth IRA in?

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.

What are the best assets for a Roth IRA?

The best assets for a Roth IRA are investments with high total return prospects, particularly over a long period of time. Slow-growing investments, such as money market funds or certificates of deposit, might not pay off since the low returns probably wouldn't cause a huge tax burden down the road. Investments that pay dividends are also a good fit (provided you reinvest them) since dividends can boost returns over time, and those reinvested dividends don't count toward your contribution limit.

Considering this, some of the best investments for a Roth IRA might include:

• Small-cap stocks and ETFs.

• International stocks (particularly emerging market companies or funds that focus on holding these types of companies).

• High-dividend stocks.

• High-dividend ETFs.

However, while the above investments could mean maximizing untaxed growth, they also come with considerable risk; high-growth stocks tend to be unproven companies with volatile stock prices. Similarly, a high-dividend stock doesn't necessarily mean its dividend is reliable, so it may not be a suitable choice for long-term retirement investing.

Highly diversified equity funds (a fancy way of saying index funds and ETFs that contain hundreds or even thousands of stocks) may be a solid middle ground. Their long-term growth potential is higher than CDs or money market funds, but they're generally less volatile than individual stocks.

One of the most popular ways to achieve this is to use an S&P 500 ETF, which aims to track the performance of the S&P 500 index. Considering these ETFs' returns should mirror the S&P 500, it's each fund's expense ratio that may be the biggest differentiator. You can see these in the table below.

Best ETFs for a Roth IRA

In addition to investing in an ETF that tracks the S&P 500, you can also invest in ETFs that track some of the asset options that we listed above, such as small-cap stocks, REITs, and high-dividend ETFs, to further diversify your Roth IRA and maximize its tax benefits. Below is a list of top-performing and popular ETFs across different categories.

Small-cap ETFs

Emerging Market ETFs

High-dividend ETFs

REIT ETFs

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.

• Traditional IRA: Withdrawals 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 may have gotten a tax pass on if you funded the account and deducted those contributions from your income taxes).

• Roth IRA: The opposite of the above is true for the Roth IRA. Withdrawals of both contributions and earnings (which have grown tax-free) from a Roth IRA are typically not taxed as long as you've held the account for five years and are at least 59½. You settled your tax tab at the beginning by funding the account with money the IRS already taxed.

» Learn more about making a Roth IRA withdrawal

What else should I consider?

On top of taxes owed on withdrawals, there are other factors to keep in mind when picking your Roth IRA investments:

Tax characteristics. If an investment generates interest income that's already exempt from taxes, it doesn't need the tax benefit offered by a Roth account. For example, dividends paid on municipal bonds 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 is an ideal home for this type of investment.

Frequency of trading activity and investments in the account. In a regular, taxable brokerage 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 one year or less, 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^[0]

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.)