How to Invest in a Roth IRA

Find out the various investment options available with a Roth IRA.

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IRAs are one of the core methods of saving for retirement. When it comes to setting up an account, you have two options: a traditional IRA or a Roth IRA. There are no age limits for opening a Roth IRA, and it's easy to set one up. Let's dive into how to invest in a Roth IRA.

What is Roth IRA?

Roth IRAs are one of the easiest ways to save for retirement. While there is no up-front tax benefit, your income is tax-free when it comes time to retire. You make contributions on an after-tax basis. And then your money grows tax-free. This means you can let the money keep growing until you need it. When you retire, you withdraw money on a tax-free basis as long as certain requirements are met.

A Roth IRA can be opened and managed by many brokerage firms, such as Ally Invest and E*TRADE for the hands-on investors. For the more hands-off investors, you can use Betterment or Ellevest.

Advantages of Investing in a Roth IRA

You can withdraw your funds from a Roth IRA tax-free at any time if you made your first Roth IRA contribution at least five years ago and are at least 59½ years old. You pay a penalty if you withdraw your money early. But you can take out funds without paying this penalty if:

  • You become disabled.
  • After your death, the distribution is made to a beneficiary of your estate.
  • You or someone in your family uses the money (up to $10,000) to buy a first home.
By allowing for tax-free withdrawals in retirement, a Roth IRA helps account holders diversify their tax base in retirement. Of course, tax rules and regulations change, and they could change in the future. But for now, any contributions made to a Roth IRA can be withdrawn tax-free.

Roth IRAs are also not subject to required minimum distributions. This is a huge benefit if you don't need to withdraw funds from your IRA in retirement.

The SECURE Act passed at the end of 2019 provides advantages when a Roth IRA is passed on to a non-spousal heir. Your heir no longer needs to wait to withdraw the money, as was true prior to the passing of this new law. But the downside is that your heir must withdraw the full amount within ten years.

>>Further Reading: Roth IRA 101 Guide

Investment Options for a Roth IRA

Depending upon the IRA custodian, there is usually a broad range of investment options available to Roth IRA account holders. These include:

Mutual Funds

Mutual funds are a solid investment option for many investors. These represent professionally managed accounts. Mutual funds come in a wide range of asset classes. Many mutual funds allow relatively small initial and subsequent investments within an IRA account. Mutual funds offer the opportunity to build a diversified portfolio.

ETFs

Like mutual funds, Exchange-traded funds (ETFs) come in a wide range of asset classes and investment styles and are professionally managed. But ETFs trade just like individual stocks while the stock exchange is open. This means that investors can use stop orders, limit orders, and similar tools. And this helps ensure they buy or sell the ETF within a certain price range.

Managed funds like ETFs and mutual funds lend themselves very well to a Roth IRA. Capital gains and any distributions stay inside the account and can be reinvested for tax-free growth until the money is withdrawn from the account.

Individual Stocks

Individual stocks offer another investment option for your Roth IRA account. Stocks provide the growth potential, and the immediate impact of any gains can be sheltered inside of the Roth IRA until funds are withdrawn tax-free in retirement.

  • Growth stocks can be an excellent fit for investing inside of a Roth IRA. These are stocks of small or mid-sized companies that seem likely to grow later on. The price appreciation and any resulting capital gains can be sheltered inside of the Roth IRA. The money can be withdrawn tax-free in retirement. You don't have to pay capital gains tax like when you withdraw money from a traditional IRA account or taxable brokerage account.
  • Another option is income-oriented stocks. These shares pay high dividends. Generally, these dividends stay in the Roth IRA with the ability to reinvest them for tax-free growth. So you don't need to pay the usual tax rate on these dividends.

Bonds

Bonds offer another great source of potential income for investors. Normally this income is taxed if held in a taxable account. But in a Roth IRA, the interest payments stay in the account and can be used for additional investments free of tax.

The best bonds for a Roth IRA include corporate bonds and other taxable bonds. Municipal bonds, whose income is tax-free, are better held inside of a taxable brokerage account.

Real Estate and Alternative Assets

Real estate provides another investing option for Roth IRAs, and you can invest in real estate either directly or indirectly:

Direct investment

Direct investment in real estate is when the property is directly owned, such as a rental property. This type of investment makes a lot of sense inside of a Roth IRA because real estate is relatively illiquid, which may dovetail with your time horizon until retirement. Also, any income from rental payments and any capital gains generated by the sale of the property remains in the plan to grow tax-free.

But you probably need to find a self-directed IRA provider to have real estate inside of your Roth IRA. That's because most IRA custodians don't offer alternative assets like real estate, commodities, or futures.

Indirect investments

Real estate investment trusts (REITs) offer indirect investments in real estate. REITs are securities backed by commercial property, residential property, mortgages, or other types of real estate-related investments. An excellent way to invest in a REIT is via a mutual fund or ETF that invests in them. You can manage REITs via services like Streitwise, which offers commercial real estate with low minimum investment requirements.


Maximum Income for Contributing to a Roth IRA

The ability to contribute to Roth IRA is subject to income limits. You must earn income from either employment or self-employment to be able to contribute to a Roth IRA. Income limits tend to change each year. The following are the limits for 2020.

Married filing jointly or qualified widow/widower

  • No limit if your modified adjusted gross income (MAGI) is less than $196,000
  • A prorated phaseout amount if your MAGI is between $196,000 and 205,999
  • But no Roth contribution is allowed if your MAGI is $206,000 or more

Single head of household, or married filing separately and the filer didn't live with their spouse at all during the year

  • No limit if your MAGI less than $124,000
  • A prorated phaseout amount if your MAGI is between $124,000 and 138,999
  • But no Roth contribution is allowed if your MAGI is $139,000 or more

Married filing separately and the filer lived with their spouse at any time during the year

  • A prorated phaseout amount if your MAGI less than $10,000
  • But no Roth contribution is allowed if your MAGI is $10,000 or more

Roth IRA Asset Allocation

The appropriate asset allocation for your Roth IRA depends on a number of factors, such as your age, your time horizon until retirement, and your risk tolerance. It also depends on the allocation of assets held in any other accounts you hold, including both taxable accounts and retirement accounts outside of the Roth IRA.

The allocation of the Roth IRA should be done in the context of your overall investment portfolio. You should also think about the asset location, which is the tax treatment of certain investments. In other words, it makes more sense for certain types of investments to be held in a retirement account (like a Roth IRA) for tax reasons.

Pros and Cons of Roth IRA Investing

Pros

  • You can withdraw the amount you contributed tax and penalty-free at any time.
  • If the rules are followed, distributions can be taken on a tax-free basis. This helps with retirement planning.
  • No minimum distributions are required from a Roth IRA.

Cons

  • There are no up-front tax benefits for making a Roth IRA contribution.
  • There are income limits connected with the ability to make a Roth IRA contribution.
  • Distributions can be subject to income tax and, in some cases, a 10% penalty if they do not meet the criteria for a qualified distribution.

Roth IRAs Can Be Another Tool for Your Retirement

Roth IRAs offer another alternative for retirement savers. The tax-free nature of the distributions can be an effective retirement planning tool. Roth IRAs offer an easy way for retirement savers to diversify their tax base in retirement, along with traditional IRAs that are taxed upon withdrawal. This is an important issue since none of us knows the direction of future tax rates. Additionally, the fact that Roth IRAs are not subject to required minimum distributions makes them a valuable retirement planning tool. Take a look at your own situation to see if a Roth IRA is right for you.

Roger Wohlner

Roger Wohlner is an experienced financial advisor, finance blogger and freelance writer based in Arlington Heights, Ill. His expertise includes providing financial planning and investment advice to individual clients, 401(k) plan sponsors, foundations and endowments. Roger contributes to his own popular finance blog, The Chicago Financial Planner, where he writes about issues concerning financial planning, investments and retirement plans. His work has been featured on Investopedia, Go Banking Rates, US News & World Report, Yahoo! Finance, Equifax Finance Blog and other publications. You can follow Roger on: Twitter - LinkedIn

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