Stocks, bonds and mutual funds are all investments you may choose to hold in an IRA. But some subcategories of these assets may be better suited to a Roth IRA than a traditional IRA.
Why are certain assets more Roth-friendly? Short answer: because of the way the IRS taxes income. The less tax-efficient an investment is, the bigger the benefit of holding it in a Roth IRA.
What should I invest my Roth IRA in?
That's up to you and your investment goals, but in general, consider holding in a Roth any investments that bring:
High growth potential, such as individual stocks that could dramatically rise in value.
Generous dividends, including real estate investment trusts (often called REITs) or other investments that pay regular streams of income.
High levels of turnover, such as actively managed mutual funds.
Frequent trading events, where investor activity triggers taxable events.
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When do I get taxed?
With both traditional and Roth IRAs, investment growth is generally not taxed as long as the money remains in the account. It’s when investors start taking distributions from their portfolios in retirement that the differences in tax treatment become clear.
Traditional IRA: Withdrawals are taxed at the account holder’s income tax rate. At that point, you’ll owe taxes on both the earnings (which have grown tax-deferred) and your original contributions (which you may have gotten a tax pass on if you funded the account and deducted those contributions from your income taxes).
Roth IRA: The opposite of the above is true for the Roth IRA. Withdrawals of both contributions and earnings (which have grown tax-free) from a Roth IRA are typically not taxed as long as you've held the account for five years and are at least 59½. You settled your tax tab at the beginning by funding the account with money the IRS already taxed.
» Learn more about making a Roth IRA withdrawal.
What are the best assets for a Roth IRA?
The best assets for a Roth IRA are investments with high total return prospects, particularly over a long period of time. Slow-growing investments, such as money markets or certificates of deposit, might not pay off since the low returns probably wouldn't cause a huge tax burden down the road.
Some of the best investments for a Roth IRA include:
Small-cap stocks and mutual funds.
Index funds.
International stocks (particularly emerging market companies or funds that focus on holding these types of companies).
High-dividend stocks.
High-dividend ETFs.
» MORE: Read our step-by-step guide to investing in stocks.
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What else should I consider?
On top of taxes owed on withdrawals, there are other factors to keep in mind.
The tax characteristics of the investments is another factor to weigh. For example, an investment that generates interest income that’s already exempt from taxes doesn’t need the coverage the Roth offers. Dividends paid on municipal bonds, for example, are already exempt from federal taxes.
Dividends paid out by REITs, on the other hand, are not sheltered from the IRS’ reach. And because REITs are known for generous dividends, the Roth is an ideal home for this type of investment.
Another consideration is the frequency of trading activity that takes place within the account — and within the investments held in the account.
In a regular, taxable brokerage account, investors who trade in and out of positions frequently expose themselves to short-term capital gains taxes. Short-term capital gains, which are profits on investments held for one year or less, are taxed at a higher rate than long-term capital gains.
For active traders, a Roth IRA is ideal: The IRS doesn’t even require you to report capital gains taxes each year. And, of course, qualified distributions in retirement are tax-free.
For the same reason, actively managed mutual funds with high turnover rates are well-suited to the Roth’s tax protections. (Side note: Passively managed funds — index mutual funds and ETFs, for example — have less internal buying and selling.)
Finally, consider your timeline when deciding whether to hold an investment in a Roth, traditional or taxable account. The longer you can let an investment ride, the higher the potential returns and number of tax dollars saved by avoiding an IRS bill when you eventually withdraw the money.
» Ready to try a Roth IRA? See our list of the best Roth IRA account providers.
