Roth IRAs are growing in popularity. As of year-end 2018, 17.6% of U.S. households—some 22.5 million—owned this type of investment retirement account, up from 9.2% in 2000, according to a 2018 survey/research report from the Investment Company Institute (ICI). Additional ICI research also indicates that one-third of IRA-holders have Roth IRAs, and their assets account for $810 billion of the $9.2 trillion held in individual retirement accounts overall. Once a rarity, Roth IRAs are offered by nearly all investment companies and financial services firms.
A Roth IRA can hold any financial asset held by its big brother, the traditional IRA (in fact, they can hold just about any financial asset, period). However, when it comes to investing in Roth IRAs, not all assets are created equal. Remember, though they share the same tax-advantaged structure, Roth IRAs differ from the traditional variety in several important ways: Contributions to them are made with after-tax, not pre-tax dollars—which means, no income tax deduction the year you make them, but also no income tax due when you make withdrawals, either (of principal, that is. Earnings are tax-free provided you've reached 59.5 and have held the account for five years). Nor are you obligated to take distributions at a certain age.
The unique characteristics of the Roth IRA mean that some investments suit it better than others. Roth IRAs, on average, include three different asset classes per account, according to ICI data. What follows is a breakdown of the most common —and which types are the most advantageous to hold.
Mutual Funds in Roth IRAs
Geared as they are to the retail investor, offering safety, diversification, and a managed portfolio for a minimal amount, mutual funds are the darling of retirement investment accounts in general and of Roth IRAs in particular. In ICI's survey, some 71% of Roth owners said they had assets in mutual funds.
Of these, equity funds investing in domestic and international stocks were the most popular by far, with 49% of Roth IRA households saying they were invested in this type of fund. Twenty-four percent of Roth IRA households held bond funds, which invest in bonds and other debt instruments.
When opting for mutual funds, whether equity or bond, the key is to go with actively managed funds, as opposed to those that just track an index (aka passively managed funds). The rationale: Because these funds make frequent trades, they are apt to generate short-term capital gains, which are taxed at a higher rate than long-term capital gains. Keeping them in a Roth IRA effectively shelters them, since earnings grow tax-free.
Individual Stocks in Roth IRAs
Individual stocks are the second-most-common type of investment held in Roth IRA accounts, with 40% of IRA households saying they had these assets in the ICI survey. The equity universe is huge, of course, but the types of equities (and equity mutual funds) best-suited to a Roth fall into two basic categories.
One is income-oriented stocks: common shares that pay high dividends or preferred shares that pay a rich amount regularly. As with the short-term capital gains mentioned above, holding these within a Roth shields them from an annual tax bite.
The second is growth stocks—small- and mid-cap companies that seem ripe for capital appreciation down the road. But it won't matter that these stocks are worth substantially more when you cash them in, after retirement—because, if held in a Roth, you don't owe any taxes on them. Remember, the whole strategy of the Roth IRA revolves around the assumption that your tax bracket will be higher later in life. Also, growth stocks can be volatile; so keeping them in a long-term retirement account that can withstand the ups and downs of the stock market over the long haul mitigates the risk.
Investors who trade equities frequently should also consider doing so from their Roth IRA, shielding their short-term capital gains from taxes—as with the actively managed mutual funds.
ETFs in Roth IRAs
What about exchange-traded funds (ETFs), that rapidly ascending rival to mutual funds? Certainly, these pooled asset baskets that trade like individual stocks can be sound investments, offering diversification and good yields at much lower expense ratios than mutual funds. The only caveat: Because most are designed to track a particular market index, ETFs tend to be passively managed (that's how they keep the costs low) and invest infrequently, so you don't really need the Roth's tax-sheltering shell so much.
Still, it wouldn't hurt to have them in your account, as 23% of the ICI survey respondents do. As with individual stocks, the ETFs to go for would be those that invest in high-growth or high-income equities.
Bonds in Roth IRAs
When they think income-oriented assets, many investors think bonds. Interest-paying debt instruments have long been the go-to for an income-oriented stream, and in the ICI survey, 24% of Roth accounts contained individual bonds, either U.S. savings bonds or other types; an additional 24% held bond funds.
Corporate bonds and other high-yield debt are ideal for a Roth IRA. It's the same principle as with the high-dividend equities—shield the income—only more so. You can't invest interest payments back into a bond, the way you can reinvest a dividend into its stock shares (a strategy to avoid taxes in regular accounts). So the Roth's tax protection is even more valuable here.
REITS in Roth IRAs
Real estate investment trusts, publicly traded portfolios of property holdings, are also big income-producers. The rich dividends they regularly produce are totally subject to taxes, so again—they are ideal for the tax-advantaged Roth.
What Not to Invest in a Roth IRA
Since Roth IRAs offer a tax shelter, there's no point in putting tax-exempt assets in one. Case in point: municipal bonds or municipal bond funds.
Money market funds, CDs, and other low-risk, cash-equivalents investments are also ill-suited for a Roth, but for a different reason. What's to shelter in an asset that isn't generating much interest, to begin with? And the liquidity they offer is wasted in an account you aren't going to touch for years.
Annuities are more complicated cases. It depends on how soon you anticipate taking distributions from the Roth. Placing a tax-deferred annuity inside a tax-sheltered IRA on its face doesn’t make a lot of sense if you've decades to go before making withdrawals. The advantage of a steady, guaranteed tax-free income stream at retirement, however, might justify this strategy—if, say, you're within five years of closing that office door.
The Bottom Line
Overall, the best investments suited to Roth IRAs are those that:
- generate high taxable income, be it dividends or interest
- have high or frequent turnover, generating short-term capital gains
- are high growth
In terms of how you should allocate assets, that depends on a range of factors, including your age. In general, younger investors with long-term investment horizons and retirement decades away, for example, would typically allocate more retirement assets to individual stocks or equity funds. Those who are retired or close to retirement would typically have a higher allocation of their investments in bonds or income-oriented investments.