When exploring your retirement savings options, you’ve probably heard about Roth IRAs. These are one of many tax-advantaged retirement accounts from which you can choose. For some, it’s one of the best options. However, before you can decide, you need to be sure of what they are and how they work.
It’s common for people to get confused when they hear the term “Roth IRA,” according to Chloe Elise, CEO and founder of the financial literacy company Deeper Than Money. “Many think a Roth IRA is the investment itself, when in actuality, the Roth IRA is just the vehicle for saving,” she told The Balance in an email. “There are many options for investments you can put inside it.”
Read on to find out the benefits of an after-tax Roth IRA and what types of investments you should have in one.
Roth IRA Advantages
First, IRA stands for individual retirement arrangement, or account. With a traditional IRA, contributions are made with pretax dollars, and you pay income taxes on withdrawals in retirement. With a Roth IRA, however, contributions are made with after-tax dollars and withdrawals are not taxed. So the main benefit of a Roth IRA over a traditional IRA is that returns on investments inside the account grow tax-free.
“It is a great tool, especially for someone who is younger and in a lower tax bracket than they expect to be in retirement,” Elise said. “If someone has the ability to contribute to a Roth IRA, I highly recommend they make the maximum annual contribution.”
For 2022, the maximum annual contribution to a Roth IRA is $6,000, or $7,000 for those age 50 or older.
Another benefit: There are no required minimum distributions (RMDs) for Roth IRAs, which means you can continue generating returns on the balance for life and also pass it to your heirs tax-free. However, keep in mind that only earned income can be contributed to a Roth IRA. Contributions may also be limited based on income and filing status; if your earned income is too high, you can’t contribute at all.
Best Investments for a Roth IRA
Roth IRAs can hold just about any type of investment, including equities, bonds, cash, commodities, mutual funds, and more. “There really is no wrong choice in an objective sense,” said David Frederick, the director of client success and advice at First Bank. “The difficulty comes with missed opportunities,” he told The Balance by email.
But using a Roth as just another retirement savings account, as you would a traditional IRA or taxable account, may not be the most strategic move. In general, it makes sense to place the investments you project to have the highest returns in the Roth IRA account, according to Doug Carey, owner and founder of WealthTrace, a financial planning and retirement planning software company. “This is due to the fact that Roth IRA withdrawals will not be taxed,” he told The Balance in an email.
Some examples of best-suited Roth IRA investments include:
Actively Managed Funds
Actively managed funds (exemplified by many available mutual funds) tend to be more expensive to own than passively managed funds (such as index funds and exchange-traded funds (ETFs). One big reason for the cost gap is because the active fund’s manager needs to make frequent trades to attempt to outperform the market. This can generate taxable short-term capital gains. However, by holding actively managed funds in a Roth, you are protected from having to pay taxes on those gains.
Short-term capital gains are the profits on the sales of assets held for less than a year. They are taxed as regular income. Long-term capital gains are levied on assets sold more than a year after acquiring them and are taxed at a lower rate.
Some stocks pay shareholders dividends, which are a share of the company’s profits, often distributed at regular intervals. Dividend income is also subject to long-term capital gains taxes; non-qualified dividends are taxed as ordinary income. Again, by holding these types of assets in a Roth IRA, you can avoid having to pay those taxes.
Real estate investments, such at REITS, can be very well-suited for a Roth IRA, Frederick said. “Depending on its structure, real estate may pay out cash that would be taxed as ordinary income, which is no problem in the Roth.” He added that real estate may create a concentrated investment position, which should be avoided in a foundational account like a traditional IRA, but fits in well in a supplemental account like a Roth.
Frederick said that high-growth, speculative investments may have an effective place in the Roth as well. For one, these types of investments can trigger potentially expensive long-term capital gains when sold, which can be avoided by investing in them via a Roth. And because you aren’t required to take RMDs from a Roth, “you may be able to hold the investments relatively longer in pursuit of a return,” he added.
If you’re looking to set aside some of your retirement funds for a newer, highly volatile investment such as crypto (and are comfortable with the risks), a Roth IRA can be one of the best places to do this, for the reasons mentioned. But be aware of the account’s rules about holding alternative investments, as not all providers allow them.
Most IRA custodians won’t allow you to invest in alternative assets such as crypto, promissory notes, tax-lien certificates or private funds. Instead, you’ll likely need a self-directed IRA, which lets you buy into these types of investments.
What You Don’t Want in a Roth IRA
On the other hand, lower-yield investments are not ideal to hold in a Roth IRA. That’s not to say they’re bad investments. Instead, you’d be better off keeping them in a different type of account. “Because their balances will not grow like equity investments will over time—especially with interest rates still low—the tax benefits of the Roth IRA are diminished,” Carey said. Those types of funds would be better off in a traditional IRA or a taxable account, he added.
Below are a few examples of investments that aren’t ideal for a Roth IRA.
Some bonds, such as corporate bonds, have the potential to produce high yields. Most bonds, however, are considered lower-risk investments that provide modest returns. U.S. savings bonds, Treasury Inflation-Protected Security (TIPS) bonds, and other low-yield bonds are a good way to offset the risk of more-volatile stocks and funds in your portfolio, but they may be better- suited for your traditional IRA or taxable account.
Annuities are complex investment tools that are best left out of a Roth IRA. These insurance contracts come with their own tax advantages, but those advantages are superseded by the tax rules of the Roth. In addition, if you ever decide to move the money elsewhere, you might have to deal with surrender charges.
Funds that are passively managed, such as index funds and ETFs, don’t come with as many fees and tax consequences and their actively managed counterparts. So while including them in your Roth IRA portfolio isn’t necessarily a bad idea, you won’t reap the same kind of savings.
One of the main reasons to keep a portion of your money in a savings account, money market account, or even a certificate of deposit (CD) is to maintain some liquidity, especially for emergencies. So holding one of these accounts in a Roth IRA or any other long-term tax-advantaged retirement account is somewhat pointless. Plus, deposit accounts tend to be the lowest-yielding savings options, meaning they don’t really benefit from a Roth’s tax benefits.
The Bottom Line
In general, your retirement savings strategy should be to invest in a wide variety of assets. You shouldn’t let certain taxation rules deter you from putting your money in tried-and-true investments such as bonds or index funds.
That said, you can be calculating about how you invest for retirement, and use a variety of account types to make the most of your investments. A Roth IRA is just one option at your disposal.
Frequently Asked Questions (FAQs)
How do you open a Roth IRA?
Once you determine that you’re eligible to open a Roth IRA, choose a provider. It can be a bank, credit union, brokerage firm, robo-advisor, or other investment company. Next, fill out an application and provide a few personal details, such as your driver's license number, Social Security number, beneficiaries and bank routing number so that you can fund the account. Once funded, you can choose your investments.
When can you withdraw from a Roth IRA?
Contributions to a Roth IRA can be withdrawn at any time without taxes or penalties. When it comes to withdrawing the earnings on those contributions, you might have to pay taxes and/or penalties. That may be the case if you’ve had your Roth IRA for less than five years. If you use the money for certain reasons, such as buying your first home or paying for qualified education expenses, you’ll only need to pay taxes. You’ll also be charged penalties and taxes if you withdraw your earnings before age 59 ½.
How much can I contribute to my Roth IRA?
The maximum amount you can contribute to a Roth IRA for tax year 2022 is $6,000, if you’re under the age of 50, or $7,000, if you’re 50 or older. However, the specific amount you’re allowed to contribute is dictated by your modified adjusted gross income (MAGI) and filing status. The IRS has guidelines to help you determine how much you can save in your Roth IRA.