The best Roth IRA investments are those that take advantage of the Roth IRA’s unique tax advantages. Asset allocation receives a lot of attention, and rightly so. A strong mix of diversified investments can help stabilize your investment portfolio. But just as important as asset allocation is asset location, or the placement of certain types of investments.
Asset location is a very broad topic, so for this article, we are going to zero in on the unique tax advantages offered by Roth IRAs, and other Roth accounts, like a Roth 401(k). Using this information, we will look at the best Roth IRA investments, as part of a larger investment strategy.
The Power of the Roth IRA
Roth IRA accounts offer a distinct tax advantage – contributions to a Roth IRA have already been taxed, but the earnings and qualified withdrawals will be tax free. This advantage makes opening a Roth IRA an essential part of a balanced retirement plan. Savvy investors can also leverage this tax advantage in unique ways. Let’s look at how we can do this.
One of the inherent conflicts with Roth IRA’s is that you can hold an almost unlimited number of of investments in them. After all, a Roth IRA is an IRA at it’s core, and that means two things:
- It can be held in an account that’s completely self-directed, and
- Self-directed accounts can have a lot more investment options than managed retirement accounts, like 401(k) plans.
Why does this flexibility present a conflict? Because not all investments are necessarily suitable for a Roth IRA. Or put another way, some types of investments work better in a Roth IRA than others.
Best Investments for a Roth IRA
Let’s consider the best Roth IRA investments, and why they are best held in a Roth IRA compared to a Traditional IRA or a taxable investment account. We’ll also look as some investments that might be better held elsewhere.
High Dividend Stocks
High dividend stocks are a good fit for Roth IRA accounts precisely because they generate a high level of income. If they are held in a taxable account, not only can they generate a tax liability, but there’s even the potential to move you into a higher tax bracket if the total dividend income is particularly high.
You can generally get around this problem by reinvesting those dividends to buy more shares in the companies that issue them. But if you have other plans for the dividend income, such as accumulating it to buy unrelated investments, you could be creating a tax liability.
By keeping high dividend stocks in a Roth IRA account, there are no tax consequences to the dividend income, no matter what you choose to do with it. The fact that you have them in a tax-sheltered account gives you full control of the income for investment purposes.
Real Estate Investment Trusts (REITs)
As a general rule, REITs pay dividends that are higher than what you can get on interest-bearing investments, and even on dividends from stocks. If you are receiving REIT dividends of between 5% and 8% per year, you should want to make sure that that income is fully tax-sheltered. That will enable it to continue to grow and increase your investment portfolio.
Actively Managed Mutual Funds
The issue with actively managed mutual funds is that they usually generate short-term capital gains. The disadvantage here is that short-term capital gains are taxed as ordinary income. That means that the tax rate you will pay on short-term capital gains can be considerably higher than what you will pay on long-term capital gains, that are largely tax-advantaged.
Since actively trading mutual funds tend to trade stocks much more than passively managed funds, such as index funds, there is a much greater likelihood of producing short-term capital gains on a regular basis. By holding these funds in your Roth IRA, those gains will be completely sheltered from income taxes, for both federal and state purposes.
High Frequency Stock Trading Accounts
The same principle is at work here as with actively managed mutual funds. If you are a high frequency stock trader within your own investment portfolio, than a Roth IRA is the perfect vehicle for that purpose.
High-frequency trading has great potential to produce short-term capital gains. That’s because the primary purpose of high-frequency trading is usually more about producing gains than about protecting from income taxes. And since you can hold a Roth IRA with the very best trading brokerage firms available, it will work better for high-frequency trading than an employer-sponsored plan, like a 401(k).
Now the same could be said of using a traditional IRA for high-frequency trading. However, if you are particularly successful as an active trader, the Roth IRA will be by far the better account to use. This is because the gains that you produce in your account will be fully tax-free if you hold them until you are at least 59 1/2 years old, and have been in the plan for at least five years.
By contrast, traditional IRAs are only tax-deferred, which means that you will have to pay taxes on your gains when you begin withdrawing the money.
High-yield bonds are very similar to high dividend stocks in regard to Roth IRAs. Since they produced a regular stream of income, they are better held in a tax-sheltered plan, like a Roth IRA. But this is even more important with high-yield bonds than it is with high dividend stocks. High-yield bonds do not provide you with the ability to avoid taxes by reinvesting the income, like high dividend stocks do.
A Roth IRA, or other tax-sheltered retirement plan, should be the place where you hold most of your high-yield investments. This will ensure that the regular returns that you receive on them will be sheltered from income taxes, at least until you are prepared to begin taking income. And of course with a Roth IRA, the income won’t be taxable even then.
Some Investments that Shouldn’t be in a Roth IRA
Despite the obvious benefits to holding any of the above investments in a Roth IRA, there are some investments that would be more appropriately held in a different type of plan.
Low-yield Cash-type Assets
A Roth IRA is a retirement plan, which means that it should have a strong orientation toward growth. Low yielding cash type assets are not suitable for this purpose. There’s also a school of thinking that says that a Roth IRA can double as an emergency fund. This once again ignores the fact that a Roth IRA is actually a retirement plan. Low yield cash type investments should generally be found in non-tax-sheltered plans, such as an emergency fund. They simply do not produce sufficient income to justify occupying a significant corner of a retirement account.
The main attraction of municipal bonds is that they generate tax-free income. But since virtually all income produced within a Roth IRA is already tax-free, there is no point to holding municipal bonds in such an account. Your interest income is already protected from taxes.
It’s absolutely true that you should favor growth type investments in a Roth IRA, or any other type of retirement plan for that matter. But at the same time, you can’t completely ignore the importance of capital preservation. For that reason, you should necessarily avoid the types of investments that have the potential to produce very large gains, but also crushing losses.
Assets That Generate Long-term Capital Gains
This is actually a mixed bag. Naturally, you want to include growth type assets in your Roth IRA account, for all of the reasons given above. But at the same time, since long-term capital gains generally offer lower tax rates, it will be worth the effort to hold at least some of them outside of a retirement plan. These investments may be better in a taxable investment account, depending on how your portfolio is allocated.
What it comes down to is that while it is possible to put virtually any type of investment into a Roth IRA, some investments clearly work better than others.