When you are saving for retirement, it’s best to do all the necessary research about what types of investments should go into each of your retirement accounts. The types of investments you should put in a traditional individual retirement account (IRA) differ from the investments that should go into a Roth IRA. Why? Because the rules are different for the traditional IRA and the Roth IRA. These rules range from the way the traditional and Roth IRAs are taxed to how you take distributions out of each type of account. We look at some of the best Roth IRA investments for 2023, and why they are so attractive.
For help with any type for retirement planning, consider working with a financial advisor.
Roth IRAs are similar to traditional IRAs except for the money you contribute is after-tax dollars. Later, in retirement, you do not pay taxes on the money you withdraw from a Roth IRA because those contributions have already been taxed. This one fact makes some investments better suited for the Roth IRA rather than the traditional IRA. You don’t have to take a required minimum distribution (RMD) with a Roth IRA, unlike the traditional IRA. Since you do not have to take an RMD each year, you can either make withdrawals or not, potentially passing the money on to your heirs.
Since the contributions to a Roth IRA are not taxed when you withdraw them, this type of IRA is ideal for growth stocks, income stocks, REITs, high yield corporate bonds and actively managed mutual funds. Any financial asset that generates a high level of current income, and will be taxed is a possible investment for the Roth IRA.
What Should (and Should Not) Be in a Roth IRA?
In general, the best investments for your Roth IRA are those that generate highly taxable income such as dividends, interest and short-term capital gains. If you purchase these types of investments, you will substantially improve the tax efficiency of your portfolio and lower your overall tax liability. The earnings from the investments in your Roth IRA will never be taxed as you withdraw them if you follow all the rules about Roth IRAs.
It makes little sense to put low-yielding investments into your Roth IRA. Examples are money market mutual funds, certificates of deposit and all other cash-equivalent investments. This type of investment is earning very little interest, so there isn’t much to tax-shelter. Annuities are another investment that you might not want in a Roth IRA, at least if you’ve got a long time horizon before retirement. They are tax-sheltered. A few years before retirement, one strategy is to move them into your IRA if possible. Municipal bonds usually enjoy tax-exempt status, so they do not need the power of the Roth IRA.
Exchange-traded funds (ETFs) are very popular, but part of the reason is that most are passively managed because they track one of the many market indexes. A passively managed fund does not make many trades so, for this reason, they have less need of the tax-shelter of a Roth IRA.
Choose These Investments for Your Roth IRA
Here are investments that may need the power of a tax-sheltered Roth IRA:
- Growth stocks: The universe of growth stocks includes small- and mid-cap stocks along with some large-cap stocks. They offer capital gains, both short- and long-term and many offer some level of dividends. Including your growth stock investment in a Roth IRA is a good strategy due to the type of income they generate.
- Income stocks: Income stocks are those of companies that have completed their growth phase. Instead of capital gains, they tend to generate dividends. If you don’t tax shelter this type of stock, you’ll pay taxes on that dividend income.
Mutual funds are a popular investment for IRA accounts. They generate dividend income and often, at the end of the year, capital gains are distributed to investors. You can benefit by including mutual funds in your Roth IRA so both dividend and capital gains will be tax-sheltered. Choose actively managed mutual funds instead of index funds. Active managers tend to make a lot of trades. If you invest in actively managed funds, you can get some excellent investments but with the income resulting from trades, as well as dividends, being tax-sheltered.
Real Estate Investment Trusts (REITs)
There are two ways to invest in real estate for your Roth IRA. The indirect method is to purchase shares of a REIT, which pay a high level of dividends. They are typically invested in many types of property, ranging from apartment buildings to cell towers. They also offer some capital appreciation.They are required, each year, to distribute 90% of their dividend income to their investors so you really need a tax-shelter for them if you invest in REITs.
When you invest in the bonds that corporations issue to raise money, you earn interest income during the life of the bond. In particular, if you invest in high-yield corporate bonds, you need a tax-shelter for your interest income. High-yield corporate bonds have more risk than a government bond since they are looking to make a higher return by taking on more risk.
There are all sorts of rules you have to follow based on what type of retirement account you are funding, whether it be a traditional IRA or a Roth IRA. Generally, you will want three types of securities in your Roth IRA. You’ll benefit from including growth and income stocks, investments that generate high levels of interest and dividend income.
Tips on Investing
- Investors have a myriad of choices of securities to put into a Roth IRA, so a financial advisor can save you time as well as help you make good decisions as you pick securities. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to see how capital gains affects your taxes, check out SmartAsset’s capital gains calculator.
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