When your Roth IRA is held by a brokerage, the firm can facilitate the purchase of exchange-traded funds (ETFs).
Including ETFs in your Roth IRA can be an inexpensive and effective way of investing in your retirement. The returns you'll see from adding carefully selected ETFs are magnified by the tax-free growth afforded by a Roth IRA.
- ETFs provide diversification and access to specialized markets for your portfolio.
- Typically, ETFs have lower fees than mutual funds, making them a cost-effective investment.
- Growth and income ETFs are a good fit to include in a Roth IRA because investment gains and withdrawals are tax-free.
Benefits of ETFs in a Roth IRA
For example, there are index ETFs that track specific indices such as the S&P 500. There are also tactical-allocation ETFs that are managed by professionals and provide a dynamic portfolio in one fund by adjusting to ever-changing market conditions.
However, creating leverage within a Roth IRA can be next to impossible due to investment restraints on retirement accounts. Including a leveraged ETF in your Roth IRA is one way to solve this problem.
A leveraged ETF uses derivatives and debt to boost the returns of the underlying index it tracks. Keep in mind that while returns can be boosted on the upside, leveraged ETFs can also amplify losses, making them riskier investments. Leveraged ETFs are recommended for sophisticated investors with a high risk tolerance.
Choosing ETFs for a Roth IRA
ETFs simplify the task of investing. They trade like a stock during market hours and provide investors access to a basket of many stocks in one product. At the same time, choosing the best ETFs for retirement can be challenging due because there are so many available.
ETFs trade on an exchange like stocks, unlike mutual funds, which can only be purchased at the end of each trading day.
Contributions to Roth IRAs are made with after-tax dollars, which means investments grow tax free and you also don’t pay any tax on withdrawals at retirement. More aggressive and growth-oriented funds are appropriate for a Roth IRA because of the tax advantages.
If you are nearing retirement or are already retired, you may want to choose ETFs with high income distributions. These could be distributed to you as a retirement income without tax.
Scott Bishop, CPA, PFS, CFP®
STA Wealth Management, LLC, Houston, TX
For investors who want to use complex investing strategies, ETFs are sometimes the only way to access such strategies in a Roth IRA. For instance, selling stocks short in a Roth IRA isn't typically allowed. However, you can buy ETFs that are designed to move in the opposite direction as a stock market index or other benchmarks. These inverse (or short) ETFs give you similar returns to short selling.
Also, Roth IRAs don't allow you to trade on margin, so you can't use your retirement account to make leveraged trades. You can, however, buy shares of leveraged ETFs that offer a multiple of the daily returns on a particular type of investment, which will give you many of the same return characteristics that buying a fund on margin would.