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Updated on Thursday, December 10, 2020
Roth IRAs are retirement savings vehicles that allow participants to make after-tax contributions (as opposed to pretax contributions to traditional IRAs). Account earnings then grow tax-deferred. If the account holder meets certain requirements, withdrawals after age 59 and a half are entirely tax-free, including earnings.
Roth IRAs are a popular choice for retirement savings. According to the Investment Company Institute (ICI), 24.9 million households in the U.S. owned Roth IRAs in 2019. Find out whether you are eligible to join those ranks and whether a Roth IRA is right for you.
Roth IRA: contribution limits
For the 2020 and 2021 tax years, investors can contribute a maximum of $6,000 to a Roth IRA. Taxpayers who are 50 years of age or older can contribute an additional $1,000 in catch-up contributions for 2020 and 2021 for a total limit of $7,000.
Roth IRA contributions phase out between $124,000 and $139,000 in income for single taxpayers (in 2020; amounts are $125,00-$140,000 for 2021) and between $196,000 and $206,000 in combined income for married taxpayers filing jointly ($198,000-$208,000 for 2021.
Roth IRA tax benefits
As a Roth IRA investor, you can invest your account assets in virtually any available investment vehicle. This includes alternatives such as stocks, bonds, put and call options, mutual funds, bank deposits, and exchange traded funds (ETFs). However, because of the unique tax characteristics of Roth IRAs, conventional wisdom argues that some investments may offer more advantages than others.
As noted earlier, Roth IRA investors get no upfront tax break. But when you take distributions, all withdrawals (including earnings) are tax- free as long as you are at least 59 and a half and the account has been in existence for at least five years (as opposed to traditional IRAs, where all distributions are taxable, including earnings).
The unique tax treatment of Roth IRAs, where you pay no tax on distributions, suggests that you consider choosing investments that have the potential to pay high taxable income (and hopefully a higher yield) and concentrate on finding vehicles that offer those characteristics.
Smart investments for a Roth IRA
Here are three investment characteristics that may be well-suited to your Roth IRA:
- They have high dividends, including real estate investment trusts (REITs), utility stocks and the stocks of companies. Of course, some mutual funds also hold these kinds of investments.
- They are actively managed or traded, meaning there is high potential for taxable capital gains. This might include an actively managed mutual fund or a portfolio of stocks that you expect to trade regularly.
- They offer the potential for high growth. Examples might include so-called small-cap stock mutual funds as well as international stock mutual funds that are known to have the potential to grow over the long term. “Small-cap” refers to companies with a small market capitalization. While many consider small-cap companies to have a high potential for growth, they also carry more risk and are more volatile than larger companies.
In contrast, putting investments such as bank deposits, money market funds or low-growth stock mutual funds that pay low dividends into a Roth IRA may not be the best idea because these investments grow slowly and won’t ultimately result in a particularly high tax bill. That means there are few advantages to putting them in a Roth IRA, where all investment income — including dividends and capital gains — ultimately will be tax-free.
Kenneth F. Robinson, a certified financial planner for Practical Financial Planning in Cleveland, takes a narrower view on the best Roth IRA investments. In his mind, a tax-focused approach to investing can make a difference. His first suggestion is that investors put “investments that will grow the most” in Roth IRAs. For Robinson, those include small-cap stock mutual funds as well as international stock mutual funds. Robinson explained how holdings in these two investment categories “have historically earned the most over time.”
Robinson emphasized that if stocks are investments for the long run, “you have to look at them in the long run.” Over a period of, say, 15 years, he said, small-cap and international stocks and mutual funds “typically come out at or near the top” in comparison to their peers in terms of performance. Overall, Robinson thinks investors should look for investments with the potential for the greatest long-term growth.
High-growth investments in a Roth IRA are particularly appropriate for younger investors. Someone who is, say, 35 years old, will have 30 years or more for their Roth IRA to grow. The growth period can be even longer, as Roth IRA owners aren’t required to take minimum distributions based on their life expectancy from their account beginning at age 70 and a half. As a result, the growth period could be 40 years or more, emphasizing the importance of selecting investments that have the greatest potential for long-term growth.
The bottom line
Investing in a Roth IRA can be a great way to accumulate tax-free retirement income. However, the key to that strategy is choosing investments for your Roth IRA that have the potential to grow significantly over time. Doing so will ensure that you take maximum advantage of the tax benefits Roth IRAs offer.