Roth IRAs are a popular way to save for retirement, and with good reason. They offer many benefits, including tax-free growth on your contributions and earnings. While you can’t deduct your contributions (as you can with a traditional IRA), the money you withdraw someday will be tax-free, as long as you meet certain rules.
Of course, you want to make the most money possible on the money you invest. So how do you find the Roth IRA that offers the best rates?
- The rate you'll earn on a Roth IRA depends on the investments you've chosen for it.
- Some investments, such as CDs and bonds, can have predictable interest rates.
- Stocks and stock funds are much less predictable but may provide a greater rate of return over the long term.
Investing Your Roth IRA
To begin with, a Roth IRA isn't an investment in and of itself and doesn't pay a particular interest rate. It's simply a vehicle that you can use to invest in other things. What you choose to invest in will determine your rate of return.
Some common investments for Roth IRA accounts include:
- Mutual funds
- Exchange-traded funds
- Certificates of deposit (CDs)
If you have a self-directed IRA (SDIRA), you can choose from even more kinds of investments, including real estate. Most financial institutions, such as banks, mutual fund companies, and brokerage firms, offer only traditional and Roth IRAs. If you want to invest in something besides the usual suspects (stocks, bonds, etc.), you will need to open a self-directed IRA with a firm that specializes in that type of account.
Predicting Your Rate of Return
It’s easy to estimate the interest rates you might expect from fixed-rate investments, like a certificate of deposit from a bank or brokerage firm, or a corporate or government bond. With other types of investments, it can be much harder, if not impossible.
In the case of stocks, companies that have paid dividends at a consistent rate over the years are relatively predictable, at least as far as dividends go. But their share prices will still fluctuate, depending on the overall direction of the market and that company's particular fundamentals.
With mutual funds and exchange-traded funds, your return will depend on what they invest in. An index mutual fund or ETF, for example, invests in a specific stock or bond index, such as the S&P 500, and its fortunes are tied to the performance of that index. With actively managed mutual funds, on the other hand, performance will depend on how well the manager did in choosing investments for the fund's portfolio. Both indexes and fund managers can have good years and bad—up 15% one year, for example, down 15% the next.
Mutual funds are required to report their past performance, but that doesn't tell you how well they'll do in the future.
You can consult a mutual fund's prospectus to see how it performed over various periods, such as the past 10 years. But as the fund companies are quick to note, "Past performance is no guarantee of future results."
Over time, however, stocks have outperformed bonds and other fixed-income investments; so, if you are in it for the long haul, stocks or stock funds could be a good choice. Just don't expect a high rate of return in any given year.
As with investing outside of retirement accounts, the safest way to build a Roth IRA portfolio is to diversify among several different types of investments, such as a variety of stock and bond funds. A simple way to do that is to buy a target-date fund, which invests in a diverse portfolio based on how many years you have to go before retirement or some other important milestone.