By NerdWallet. March 06, 2014, 01:07:07 PM EDT
It’s no secret why the Roth IRA is exploding in popularity. a tax-free withdrawal at retirement is quite appealing, especially to the younger investor who has several decades to invest before retirement.
However, a lesser-known benefit of a Roth IRA is that you have freedom of choice in your investments, including stocks, exchange-traded funds (ETFs), bonds, CDs, Treasuries and more.
Here, we will highlight the benefits of a Roth IRA, plus offer some guidance on how to go about choosing from a wide range of investment options.
Benefits of a Roth IRA
The most notable benefit to starting a Roth is that you can withdraw your money tax-free at retirement. If you start an account now and earn $500,000 on your investment by the time you retire, you will not be taxed on those earnings. With a 401(k), you’d be taxed at your income rate when you retire. So if your tax rate is 28%, you’d end up paying $140,000 on your $500,000 in earnings.
There is one trade-off. Unlike a 401(k) or traditional IRA, which is taken out of a paycheck before taxes, a Roth IRA is funded with after-tax contributions. So, unlike a 401(k), you don’t have the advantage of lowering your taxable income.
There are limits to how much money you can contribute to a Roth IRA. For 2014, you can contribute up to $5,500, or $6,500 if you’re over 50. Contribute any more than that, and the IRS will tax you on an excess IRA contribution. A 401(k), on the other hand, allows you to contribute up to $17,500.
Another Roth IRA advantage is you can withdraw your contributions anytime, without penalty (but not your earnings). For example, if you add $5,000 of your own money to a Roth IRA and your investments earn $6,000, you can withdraw up to $5,000 – the amount you put in. This can be really important, especially if you need to access that money in the event of an emergency.
The case is not the same for a 401(k). To make a withdrawal before age 59 1/2, you’ll face a 10% penalty on top of the taxes you will pay. You might be able to take out a loan against your 401(k),
but that is not recommended.
Roth IRA Investment Allocation
There are thousands of investment options you can choose from. So where do you begin?
First, it’s important to understand the answer to this question depends on your age, your investment goals and your risk tolerance. If you are young, you might be willing to take on more risk because you have plenty of time to make up for any losses. If this is the case, you would be better suited to invest primarily in stocks and less in bonds.
A simple rule of thumb is to subtract your age from 100. That figure represents the percentage of your portfolio that should be allocated towards stocks. So if you are 30 years old, a 70/30 ratio of stocks-to-bonds might make sense. As you get older, it is generally recommended that you shift to a more conservative approach and invest in income-producing bonds.
Roth IRA Investment Options
A great start is to find low-cost ETFs that have a good yield and are designed to track the overall market. ETFs can contain hundreds of individual stocks, providing diversification and lowering overall risk.
That makes owning a diversified ETF safer than owning just one or two individual stocks, because you never know what unexpected problems a company might face. If you are going to go the route of choosing individual stocks, you might want to consider owning at least 5 to 10 dividend-paying stocks. That way, if one investment choice goes bad, your entire portfolio won’t suffer as much.
What about mutual funds? ETFs tend to make better Roth IRA investments due to lower expense ratios. Mutual funds are often actively managed funds and face costs such as investment advisory fees, brokerage fees, marketing expenses and more. The average mutual fund charges between 1.3%-1.5% per year (at 1.5%, that’s $1,500 for a $100,000 investment), while the average ETF expense ratio is just .44%. ($440 on $100,000 investment).
If you’re going to go with mutual funds, make sure you know what the fund’s expense ratio is, because a fund with a high expense ratio will take a big bite out of your earnings over time. You’ll also want to know the fund’s performance and track record, which can be found in the fund’s prospectus.