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There are a variety of investment options investors can choose from to build a portfolio for their Roth IRA, a type of tax-advantaged retirement account. Compared to traditional IRAs, a key feature of Roth IRAs is that they are allowed to grow tax-free, although contributions to the fund are not tax deductible. Upon retirement, investors can withdraw funds without paying taxes or penalties as long as they follow the Roth IRA withdrawal rules. Investors who have reached at least age 59.5 and have contributed to their Roth IRA for more than five years will be eligible for tax-free and penalty-free withdrawals.
Investors building a Roth IRA to save for retirement will want to design a portfolio using a long-term buy-and-hold approach. A strong portfolio will be diversified across different asset classes, such as stocks and bonds, and across market sectors. Additional diversification can be achieved by investing in assets from different geographical regions. Investors should also focus on cost minimization, as cost is a major factor in determining long-term returns.
A few basic index funds, including exchange-traded funds (ETFs) and conventional mutual funds, may be enough to meet most investors’ diversification needs at minimal cost. At first glance, the tax efficiency of ETFs may seem to make them a preferred fund option since they do not regularly distribute capital gains. But capital gains aren’t taxed in a Roth IRA, so ETFs lose one of their key advantages over mutual funds. Therefore, investors should consider both ETFs and mutual funds when considering investments for their Roth IRA.
Key points to remember
- Roth IRAs are a type of tax-efficient retirement account that should be invested in with a long-term perspective.
- A good foundation for a Roth IRA portfolio is a combination of a broad-based US equity index fund and a broad-based US bond index fund.
- Investors looking to increase their diversification might consider adding a global foreign equity index fund or even an emerging markets fund for those with a greater appetite for risk.
- Investors will likely want to shift to less risky assets as they approach retirement.
US Equity Index Funds
One of the central components of a long-term retirement portfolio is a broad-based US equity index fund, which will serve as the main driver of growth for most investors. Investors can choose either a total market fund or an S&P 500 index fund. U.S. total market funds attempt to replicate the performance of the entire U.S. stock market, including small- and mid-cap stocks, while an S&P 500 index fund focuses entirely on large caps. The first type of fund is likely to show slightly higher volatility and produce slightly higher returns, but the difference will be quite small in the long run. Indeed, even total market funds are typically heavily weighted toward large caps.
Investors can also benefit from the low costs associated with the passive management characteristic of index funds. There is strong evidence that index funds, which attempt to mimic the performance of an index by passively investing in the securities included in the index, generally outperform actively managed funds over the long term. The main reason for this outperformance is cost differences. However, there are certain investment categories where low-cost active funds tend to outperform passive funds. A passively managed US equity index fund, when held for the long term, has the potential to benefit from the growth of the US stock market over time. Such a strategy can avoid the large trading costs of actively managed funds whose managers often try to time the short-term highs and lows of the market.
A broad-based US equity index fund carries a certain degree of risk, but it also offers investors some pretty strong growth opportunities. It’s one of the foundations of a long-term retirement account. However, for those with a very low tolerance for risk or approaching retirement age, a more income-oriented portfolio may be a better option.
US Bond Index Funds
Adding a US bond index fund to an investment portfolio helps reduce overall portfolio risk. Bonds and other debt securities offer investors more stable and secure sources of income than stocks, but they tend to generate lower returns. A cheap bond fund that tracks a US global bond index is ideal for giving investors broad exposure to this less risky asset class. An aggregate bond index typically provides exposure to treasury bills, corporate bonds, and other types of debt securities. Investors looking to build a long-term retirement portfolio will want exposure to both stocks and bonds, which they can get through a single stock index fund and a single index fund. of bonds. The exact ratio of equities to bonds will depend on two main factors: how close the investor is to retirement age and how risk averse it is.
The traditional investment approach advocates a 60/40 portfolio (60% stocks and 40% bonds) which will meet the needs of most investors, and that the proportion of stocks to bonds should decrease to as the investor ages. Another traditional criterion was “100 minus your age”. This means that a 30 year old should own 70% stocks and 30% bonds, and at 40 they should have the 60/40 portfolio. But that approach has changed for many top financial advisers and investors, including Warren Buffett. Many financial experts today recommend holding a higher percentage of stocks, especially as people live longer and are therefore more likely to outlive their retirement savings. Investors should always consider their own financial situation and risk appetite before making any investment decision.
A broad based US bond or fixed income fund is generally less risky than an equity fund. However, bond funds don’t offer the same growth potential, which usually means lower returns. They can be useful tools both for medium-risk investors and as part of a portfolio diversification strategy.
Global Equity Index Funds
Investors can further diversify their portfolios by adding a global equity index fund that holds a wide selection of non-US stocks. A long-term portfolio that includes a global equity index fund provides exposure to the broader global economy and reduces exposure to the US economy in particular. Inexpensive funds that track an index like the MSCI ACWI EX-US or the EAFE index offer broad geographic diversification at a relatively low cost.
Investors with a higher tolerance for risk may choose to invest in an international index fund with a particular focus on emerging market economies. Emerging countries, such as China, Mexico and Brazil, can show higher, but more volatile, economic growth than the economies of developed countries, such as France or Germany. While also riskier, a portfolio with greater exposure to emerging markets has traditionally produced higher returns than a portfolio with a greater focus on developed markets. However, emerging markets face particularly heightened risks amid the ongoing COVID-19 pandemic.
Consistent with modern portfolio theory, risk-averse investors will find that investing in a broad-based US equity index fund and a broad-based US bond index fund provides a significant degree of diversification. In addition, the combination of a US equity index fund, a US bond index fund and a global equity index fund provides an even greater degree of diversification. Such an approach has the potential to maximize long-term returns while minimizing risk.
What is best to invest in for a Roth IRA?
Some of the best investments for a long-term retirement account like a Roth IRA are a few basic, inexpensive index funds. A single low-cost US equity index fund and a single low-cost US bond index fund provide enough diversification to maximize returns and minimize long-term risk. For more diversification, investors can also include a low-cost global index fund.
Can you choose your own investments in a Roth IRA?
Yes. Investors can open a Roth IRA using an online broker and choose the types of investments they want to include.
Can you have two Roth IRAs?
Yes. There is no limit to the number of Roth IRAs you can have. However, increasing the number of Roth IRAs does not increase the total amount that can be contributed each year. Whether you have one IRA or multiple IRAs, the total contribution limit on an investor’s IRAs is the same.
The essential
Investors looking to save for retirement with a Roth IRA will want to focus on the long term and choose investments that are inexpensive and offer significant diversification. One of the easiest ways is to invest in a few basic index funds. Ideally, a strong portfolio will contain a single US equity index fund, which offers broad exposure to US economic growth, and a single US bond index fund, which offers exposure to relatively safer income-generating assets. For added diversification, investors should consider a global equity index fund, which offers exposure to a wide range of developed and emerging markets.
