The best Roth IRA investments are the ones that can take advantage of the way Roths are taxed. There are no upfront deductions on contributions, but your investments grow tax-free inside the account. And withdrawals in retirement? They're tax-free, too—even on the earnings.

To take full advantage of the Roth IRA's tax-sheltering properties, it's best to hold investments that would otherwise trigger substantial taxes. Investments with high growth potential, big dividends, or high levels of turnover are prime candidates.

Key Takeaways

  • Some investments take better advantage of a Roth IRA's unique characteristics.
  • Overall, the best investments for Roth IRAs are those that generate highly taxable income, be it dividends or interest, or short-term capital gains.
  • Investments that offer significant long-term appreciation, like growth stocks, are also ideal for Roth IRAs.
  • The Roth's tax sheltering characteristics are useful for real estate investments, but you'll need a self-directed Roth IRA for that.
  • Tax-exempt assets and low-risk cash equivalents are wasted in a Roth IRA.

Roth IRA Investment Options

A Roth IRA can hold any financial asset that a traditional IRA holds. In fact, Roth IRAs can hold just about any financial asset, period. However, when it comes to investing in Roth IRAs, not all assets are created equal.

Though they share the same tax-advantaged structure, Roth IRAs differ from the traditional variety in several important ways. The biggest difference: Roth IRA contributions are made with after-tax, not pre-tax, dollars. So, you won't get an income tax deduction the year you make them. But you do get tax-free withdrawals in retirement.

Also, unlike traditional IRAs, you aren't obligated to take distributions at a certain age from a Roth IRA. With no required minimum distributions (RMDs), your account keeps growing if you don't need the money. And when the time comes, you can pass it on to your beneficiaries.

Roth IRAs, on average, include three different asset classes per account. The unique characteristics of the Roth IRA mean that some investments suit it better than others. Here's a breakdown of the most common types of assets—and which types are the best to hold.

$810 billion

The size of assets held in Roth IRAs, out of $9.2 trillion in IRA accounts total, according to the Investment Company Institute.

The Best Mutual Funds for Roth IRAs

Mutual funds offer simplicity, diversification, low expenses (in many cases), and professional management. They are the darlings of retirement investment accounts in general, and of Roth IRAs in particular. Some 71% of Roth owners say they had assets in mutual funds.

When opting for mutual funds, 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.

These 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.

The Best Stocks for Roth IRAs

Individual stocks are the second-most-common type of investment held in Roth IRA accounts—40% of IRA households hold these assets. Of course, the equity universe is huge. 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. Typically, when you hold stocks in a non-retirement account, you pay taxes on any dividends you earn. Depending on whether they're qualified or nonqualified, the rate could be as high as your regular income rate.

But, as with the actively managed mutual funds mentioned above, holding these within a Roth shields them from that annual tax bite. In fact, as long as you obey the Roth withdrawal rules, you won’t ever pay tax on those dividends or any other earnings.

The second is growth stocks—small-cap and mid-cap companies that seem ripe for appreciation down the road. Normally, their serious growth would trigger a tax bite, albeit at lower capital-gains rates (usually 15%).

But it won't matter that these stocks are worth substantially more when you cash them in after retirement. If held in a Roth, you won't owe any taxes on them at all.

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. Doing so can shield any short-term profits and capital gains from taxes.

The Best Bonds for Roth IRAs

When they think of income-oriented assets, many investors think bonds. Interest-paying debt instruments have long been the go-to for an income-oriented stream. 24% of Roth accounts contain individual bonds, either U.S. savings bonds or other types. An additional 24% hold 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 back into shares of stock (a strategy to avoid taxes in regular accounts). So, the Roth's tax protection is even more valuable here.

The Best ETFs for 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, They offer 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). As a result, they 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 IRA households do. Low annual fees and expenses—we're talking .25% to .5%—is not the worst idea in the world, when it comes to your rate of return.

Many ETFs are index funds, which aim to match the performance of a benchmark collection of securities, like the S&P 500. There are indexes—and index funds—for nearly every market, asset class, and investment strategy.

As with investing in individual stocks, the ETFs to look for would be those that invest in high-growth or high-income equities.

The Best Real Estate for Roth IRAs

Individuals have two ways to invest in real estate:

  • Indirectly, by owning securities that own property
  • Directly, by owning property themselves

Indirect Real Estate Investments

Real estate investment trusts (REITs), publicly-traded portfolios of properties, are big income-producers, though they also offer capital appreciation. REITs invest in most kinds of real estate, including:

  • Apartment buildings
  • Cell towers
  • Hotels
  • Infrastructure
  • Medical facilities
  • Office buildings/office parks
  • Shopping centers and malls
  • Warehouses

While most REITs focus on one type of property, some hold a variety in their portfolios.

REITs are required to pay at least 90% of their income—usually derived from rents—each year as dividends to their shareholders. Normally, these dividends are totally subject to taxes, at the ordinary-income rate. But not if they're held in a tax-sheltered Roth.

Direct Real Estate Investments

You can invest in real estate using REITs—or you can go straight to the source. It’s possible to own single-family homes, multiplex homes, apartments, condos, co-ops, and even land for a Roth IRA. But you'll need a self-directed IRA to do so.

To invest in actual property, your Roth must be a self-directed IRA. You’ll need an IRA custodian that specializes in these types of accounts.

There are very specific rules regarding real estate in an IRA. For example:

  • You can’t claim deductions for property taxes, mortgage interest, depreciation, and other expenses related to the property.
  • The IRA (not you) owns the real estate. All expenses and repairs must be paid with IRA funds. And you have to buy the property using funds from the account.
  • You can’t maintain the property yourself (no sweat equity). You have to pay someone else, using IRA funds.
  • You and your family can't benefit directly from the property—like using it as a residence, office, or vacation home.

Be sure to do your homework (or work with a financial advisor) to make sure you’re in compliance. Otherwise, you could lose any tax advantages associated with holding real estate in an IRA.

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 taking the payouts.

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.

Roth IRA Asset Allocation

In terms of how you should allocate assets, that depends on a range of factors, including your age. In general, younger investors have a long-term investment horizon. They would typically allocate more retirement assets to growth- and appreciation-oriented individual stocks or equity funds.

Conversely, those who are retired or close to retirement would typically have a higher allocation of their investments in bonds or income-oriented assets, like REITs or high-dividend equities.

Get Help From the Pros

If you don’t have the time, interest, or expertise to shop for and select investments for your IRA, you have several other options.

One is to put all your IRA money into a single target-date fund. These are designed to work toward the year you plan to retire, automatically rebalancing along the way. They’re named by the year you expect to retire. If that’s 2040, for example, you would select a 2040 target-date fund, such as the Vanguard Target Retirement 2040 Fund (VFORX).

Another option is to use a robo-advisor. That’s a digital platform that builds and manages a portfolio or ETFs using algorithm-driven models. In most cases, you’ll pay a management fee of about 0.25%. However, some brokerages, including Schwab, provide this service for free.

Finally, you can work with an investment professional who can manage your IRA for you. Many brokerages offer managed accounts. An annual advisory fee typically covers the ongoing management of your money, including investment selection, rebalancing, personal service, and support.

No matter which route you choose, find out ahead of time which fees you’ll have to pay—including expense ratios, commission fees, and account fees—and what they’ll cost you each year. Left unchecked, these fees could quickly erode your earnings, leaving your nest egg a lot lighter come retirement.

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
  • Offer substantial growth/capital appreciation

These investments can truly take advantage of the way the IRS taxes income. And that means more money in your nest egg come retirement.