Stocks, bonds and mutual funds are all appropriate investments to hold in an IRA. But some subcategories of these assets are 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.
In general, consider holding in a Roth any investments that bring:
- High growth potential (individual stocks that could dramatically rise in value)
- Generous dividends (REITs or other investments that spin out income)
- High levels of turnover (actively managed mutual funds)
- Frequent trading events (where investor activity triggers taxable events)
The Roth advantage
With both traditional and Roth IRAs, investment growth is 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 tax-free because, remember, you settled your tax tab at the outset by funding the account with money the IRS already taxed.
Tax optimization in action
Let’s say an investor earmarks $5,500 to buy a handful of 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 find herself in during retirement.
House the money in a traditional IRA and she’d walk away with roughly $150,000 after paying taxes (if she was married, filing jointly and taking the standard deduction). This is why it’s wise to stash your most aggressive growers — investments with higher total return prospects — in a Roth IRA.
Investments that will benefit from tax-free growth offered by the Roth include 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 and initial public offerings, or IPOs.
» MORE: Follow these simple steps to start investing in stocks.
On the flip side, putting investments like money markets or certificates of deposit in a Roth doesn’t really pay off since these slow-growing investments earning low single-digit returns won’t amount to a huge tax burden down the road anyway.
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Other reasons to favor a Roth
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 (real estate investment trusts), 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.
For active traders, a Roth IRA is ideal.
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 capital gains taxes. Investments that are held in a taxable account for less than a year are subject to short-term capital gains, which 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.