5 Roth IRA Investments You Should Always Avoid (2024)

The Roth IRA is an investment vehicle in a class by itself. You don’t get a tax deduction for making contributions, the way you do with other retirement plans. But Roth IRAs have one feature no other retirement plan has: funds can be withdrawn from the plan on a tax-free basis once you turn 59 ½.

The only other requirement isyou must participate in a Roth IRA for at least five years.

Think about it – tax-deferred accumulation of investment earnings, then tax-free withdrawals beginning in retirement. There’s no other investment like it.

With that advantage, the potential is real to become a Roth IRA millionaire, which is a topic I even made a video about. That’s how committed I am to Roth IRAs.

But becoming a Roth IRA millionaire depends heavily on making the right investment choices. The flip side of that is knowing which Roth IRA investments to avoid. There’s all kinds of investment advice out there about Roth IRAs, and it can be confusing. But to maximize the power of the Roth IRA, you really have to invest smart.

Here are investments that definitely shouldn’t be included in your Roth IRA.

1. Penny Stocks

I did an investing video called 7 Deadly Sins of Investing. Though I didn’t include penny stocks in the list, I very well could have made this #8. They can easily be one of the biggest investment mistakes possible.

A penny stock is usually a small company whose stock trades for less than $5 per share, and usually trades over-the-counter. Some are brand-new companies, while others have been around a while and just haven’t taken off. Still others were once listed on the New York Stock Exchange, but have since been delisted due to inability to meet exchange financial requirements.

Whatever the reason why a stock qualifies as a penny stock, they’re one of the highest risks you can take with your money. People sometimes invest in penny stocks, thinking they can get 10 times their money by buying a stock at $2 then holding on until it hits $20.

That’s a nice theory, but it rarely works in real life.

Forbes contributor Richard Levick reported a few months ago that Merrill Lynch is rapidly closing the window on penny stocks. Says Levick, “If enough other financial institutions follow suit, the penny stock market could disappear altogether.” When a major brokerage firm moves toward banning these stocks, that should be a solid indication of the level of risk involved.

If you want to grow your Roth IRA slowly and steadily – which is the only real way – you’ll avoid holding penny stocks in your account.

2. Cash

Probably the safest place for the typical small investor to put their money is in a local bank account. They’re completely safe, but they don’t pay much in the way of interest. In most cases, you get a rate that’s something around 0.10%. If your bank is paying rates that low on savings and in money markets, it’s actually in good company. According to the FDIC this isthe typical rate being paid by local banks.

But that doesn’t mean you need to accept near zero interest rates to add safety to your Roth IRA portfolio.

But rather than keeping your money at your local bank, look for online banks that are currently paying well over 2%.

In fact, there are an increasing number of attractive yields on other cash type investments. For example, robo-advisors are now offering savings accounts. That’s a perfect addition, because it enables you to put some of your money into safe, high-yielding – but still liquid – savings options right within your investment account.

For example, Wealthfront offers their Cash Account, with a current yield of 2.29% APY. Betterment’s Smart Saver is paying 2.18% APY. Each is paying 20 times the rates being paid on savings accounts and more than 10 times typical money market accounts at local banks.

You’ll need to hold at least a little bit of cash in your Roth IRA account, but make sure it’s earning a lot more than you can get at your local bank.

3. Short-Term Bonds

I don’t want to imply short-term bonds should be completely avoided in a Roth IRA. But you should make sure they occupy only a small corner of your portfolio. The major reason is low yield.

For example, one of the most popular short-term bond exchange traded funds (ETFs) is the Vanguard Short-Term Corporate Bond ETF (VCSH). As short-term bond funds go, it has an impressive return at 2.97% (the 30-day SEC yield as of April 18, 2019).

The fund has only been in existence since November, 2009, which works out to be about 9 ½ years. But notice from the screenshot above, the yield over that term has been just under 3%. When you consider investors have been getting double-digit returns in stocks over the same space of time, you don’t want to have too much money tied up in relatively safe investments.

One of the best ways to determine how much you should have in fixed-income investments – commonly referred to as bonds – is using a formula known as 120 minus your age. It’s actually designed to help you determine what percentage of your portfolio should be invested in stocks. But the difference is the fixed-income percentage.

For example, if you’re 35 years old, 85% of your portfolio should be in stocks, and 15% in fixed income or bonds. That’s because 120 – 35 = 85, or 85% in stocks, and 15% in bonds/cash.

The best strategy for your Roth IRA is to create a blended portfolio that stresses stocks, but also has a minority percentage allocated to bonds and cash.

The chart below shows the results of investing $100 per month for 30 years, using two options. The first is a blended portfolio of stocks and bonds, with an average annual yield of 6%. The second shows the same savings pattern, but with 100% of the portfolio invested in a cash account paying 2.18%.

Notice the performance of the portfolio that includes a mix of stocks and bonds has twice the value after 30 years.

The moral of the story: Invest some money in short-term bonds and cash, but keep it to a minimum. Most of your portfolio needs to be in growth assets, primarily stocks.

4. Annuity - Fixed or Variable

Annuities can seem like a natural investment vehicle to hold in a Roth IRA. But there are two reasons they should be avoided.

The first is that annuities already work much like Roth IRAs. Your contributions are not tax-deductible, but your investment earnings accumulate on a tax-deferred basis. Now that’s tax-deferred as in tax-deferred. Unlike a Roth IRA, your withdrawals in retirement won’t be tax-free. But there’s little point in putting one already tax-deferred plan into another. In addition, an annuity can create certain problems for beneficiaries when the plan is held in a Roth IRA. They are, after all, life insurance products.

The second issue is fees. Annuities, whether fixed or variable, come with high fees, and are often hidden from sight. For example, I once had a client purchase a $100,000 variable annuity from another provider. It turned out the fee for the annuity worked out to be 3.54% per year! And for what it’s worth, the annualized return was just 2.79%! That’s a losing investment if ever there was one.

Unfortunately, there’s a long list of hidden costs with variable annuities. These can include surrender charges, earnings caps, tax deductions, fees for additional features, and mortality, expense in administrative fees.

That’s how you get fees of 3.54% per year.

When you add high fees to the fact that annuities come with long list of other negatives, like limited investment options and no guarantee of either investment returns or a death benefit, they absolutely need to be avoided in a Roth IRA.

5. Super Roth IRA (Beware!)

The explosion in Roth IRAs in recent years has generated a lot of big promises, particularly from directions where they shouldn’t be coming from.

One of them is whole life insurance. Now before I get into why this is a Roth IRA investment to avoid, let me first point out it that actually does have a virtue. Whole life insurance is sometimes touted as a rich person Roth IRA, and there’s good reason for this.

High-income earners are often shut out of Roth IRAs because their incomes exceed IRS limits to make contributions. Whole life insurance is a potential workaround. As Forbes contributor David Rae states, “…the Rich Person IRA (whole life insurance) is a great option for those playing catch-up (the vast majority of those approaching retirement) and for those who are already maxing out their various other types of retirement accounts”.

Whole life insurance policies offer four distinct advantages as a Roth IRA alternative:

• Roth IRA contributions are limited to $6,000 per year, or $7,000 if you’re 50 or older. No such limit applies to whole life insurance premiums.
• The investment income that accumulates within a whole life policy is tax-free, just like a Roth IRA.
• There’s no risk of loss with the cash value of a whole life insurance policy, and you typically have a minimum guaranteed annual return on your money. Roth IRA investments can lose value.
• There are no penalties for early withdrawal.

But that’s all the good news. If you’re income doesn’t exceed IRS limits, you’re certainly better off with a Roth IRA than you are with a whole life insurance policy, no matter how the life insurance is packaged.

Whole life insurance policies come with a long list of complications. For example, the only way to withdraw your funds early is to take a loan against the policy. That means you’ll be paying interest. Policies also have very high fees in the early years, and the cash value buildup is very slow. In addition, returns on whole life are notoriously low.

Consider a whole life insurance policy only if you exceed Roth IRA income limits. But if you don’t, whole life insurance is generally a below-average investment.

Final Thoughts on Roth IRA Investments to Avoid

Now that you know what type of Roth IRA investments to avoid, stay with the general investment advice. Invest most of your money in stocks, and most of that in index-based EFTs. But be sure to add a small amount – but not too much – of bonds and high-yielding cash investments.

The basic idea is to create a growth-oriented portfolio that adds some safe investments and also avoids potential disasters. Those can include low-yielding investments, assets that lose a lot of money fast, or investments that will only work for high-income individuals looking for more alternatives.