Investing in a Roth IRA is a great idea, particularly if you already have a 401(k) or Thrift Savings Plan at work.
Roth IRAs are among the simplest and most flexible types of retirement savings accounts. However, there are a lot of pitfalls that can mitigate the benefits, and deciding whether to invest in a Roth IRA or Traditional IRA is not always clear.
This guide breaks down the Roth IRA to show:
- Detailed Roth IRA Contribution Rules
- Roth vs Traditional: When a Roth Makes Sense
- The Best Investments to Put in a Roth IRA
- The Worst Investments to Put in a Roth IRA
The good and bad news is that the U.S. tax code is so complex, that there are specific types of investments that if you don’t put in your Roth, you’re basically leaving money on the table.
This article covers what key investments a savvy investor should consider.
Roth IRAs 101: Contribution Rules
A Roth IRA (“Individual Retirement Arrangement”, named after U.S. Senator William Roth) lets you invest money into an account, and then never pay taxes on any of your investment gains on that money.
Normally, you earn an income and get taxed on it, and then if you take that remaining income and invest it, you’ll have to pay taxes on the dividends, interest, and capital gains you earn. Which sucks.
But with a Roth IRA, once you pay taxes on the income you earn, you can invest some of it into an account and never have to pay dividend taxes, interest taxes, or capital gains taxes on that money.
Here’s a chart showing how much faster untaxed investments can grow compared to taxed investments, assuming a 7% annual growth rate and assuming you put in the maximum of $5,500 each year:
The chart shows what happens when you take 10%, 20%, or 30% out of the annual gains over a multi-decade period.
Different types of investments have different tax rates, and some of them can be deferred (like capital gains taxes on long-term stock holdings) while others are paid every year (like taxes on bond interest). The highest blue line represents how untaxed investments in a Roth can grow.
Roth IRAs are designed for the working, middle, and upper-middle class, so in order to qualify in 2017, you must have a modified gross adjusted income (“MAGI”) of less than $133,000 for single filers, or $186,000 for joint filers.
The good news if you make a little bit over the income limit is that you can lower your MAGI by contributing to a traditional 401(k) plan. For example, if you’re single and make $135,000 per year, and put the maximum $18,000 per year into your traditional 401(k), then your MAGI will be $117,000 or less depending on other adjustments, and you can therefore still make full contributions to your Roth IRA.
The same holds true for married couples. If they both work, both of them can contribute the maximum to their traditional 401(k) plans and chop $36,000 off of their joint MAGI. That might allow a fairly high-income couple to still open two separate Roth IRAs and contribute to them.
And if you eventually earn more MAGI than the Roth IRA contribution limits, then although you can’t contribute any more, you still get to keep your existing Roth IRA account and let it keep growing tax-free.
- If you’re under 50, you can contribute up to $5,500 per year.
- If you’re over 50, you can instead contribute up to $6,500 per year.
- Contributions must be made from “earned income”, meaning your salary, wages, and tips.
- Young or old, there is no age limit on contributions; you can contribute as long as you have earned income.
- There is no maximum age limit on withdraws. You can leave your money in as long as you want.
- You can withdraw your contributions/principle at any time with no tax penalty.
- You can withdraw your earnings with no tax penalty once you’re over 59.5 years old.
- You can have more than one Roth IRA account. But you’re limited to $5,500/$6,500 annual contributions for all of your accounts combined.
- If two people are married and have enough “earned income”, they can both open and contribute the full amount to their own Roth IRAs.
Roth IRAs are employer-independent. You can change employers as often as you want, and your Roth IRA is completely separate from them.
The deadline to contribute in a year is not December 31st of that year. Instead, it’s the tax-filing deadline for that year. So, if you want to make a contribution for the 2017 tax year, you have to make it by April 18, 2018. The reason for this is that it allows you to file and determine your tax situation, and then go back and contribute if you can.
To open a Roth IRA, sign up with a brokerage that offers the types of investments that are best for you. I have my Roth IRA at Fidelity Investments. Other good options in my opinion are Charles Schwab and Vanguard.
Roth IRA vs Traditional IRA: When a Roth Makes Sense
With a Roth IRA, you pay taxes up front and then never pay them again. With a traditional IRA, you defer taxes up front by getting a tax deduction on your contributions, defer all your investment taxes, and then pay taxes on your withdraws decades later.
So, the key question of which to contribute to is this:
Will your tax rate be higher now, or in the future?
If your taxes are lower now than you expect them to be in the future, it makes sense to pay them now and get it over with. But if you expect to have a lower tax rate in retirement, then it makes sense to defer them.
There are two variables that ultimately determine this:
- Whether you’ll make more income now or later, and therefore whether you expect to be in a higher or lower tax bracket then vs now.
- Whether the government will increase or decrease tax rates on your relevant tax bracket by the time you retire.
You can’t know either of those variables for sure.
If you’re a serious wealth-builder, then chances are your income will be higher when you’re retired, from the rivers of dividends, interest, and capital gains you’re making.
And the federal debt as a percentage of GDP keeps increasing. You want to count on a tax break in the future? I wouldn’t.
If you’re not sure, then you can split the difference. For example, you can contribute to a traditional 401(k) plan at work (which defers taxes), while also contributing to a Roth IRA outside of work (which gets taxes out of the way upfront).
Traditional IRA Rules
With a Traditional IRA, you can put in contributions ($5,500 to $6,500, depending on your age) regardless of how much money you earn. However, you only get a tax deduction to defer those taxes if you meet certain criteria, which gets complicated quickly.
And if you don’t get a tax deduction, then in many cases it doesn’t give much of a benefit over a normal, taxable account.
- If both you and your spouse lack a retirement account at work, you can get a tax deduction on up to the full contribution limit regardless of your income.
- If you don’t have a retirement account at work but your spouse does, then you can get a tax deduction on up to the full contribution limit as long as your joint MAGI is under $186,000, and a partial deduction if your joint MAGI is up to $196,000.
- And lastly, if you have a retirement account at work, then you can only get a tax deduction if your MAGI is $62,000-$72,000 for a single filer, or $99,000-$119,000 for a joint filer.
Here’s the Traditional IRA tax deduction chart for if you have a retirement account at work:
For more info, check out the list of deduction limits from the IRS here.
When to Pick a Roth
If your situation is really complex, then talking to a tax professional or certified financial planner might help. But here are some guidelines:
- If you don’t have a retirement plan at work, then it’s kind of a toss-up between a Traditional or Roth IRA. If your income is over the Roth limit, then the Traditional becomes the obvious choice.
- If you have a Traditional 401(k) plan at work and have a MAGI under $62,000, then again it’s kind of a toss-up. I’d go with the Roth.
- If you have a Traditional 401(k) plan at work and make over $62,000, then forget about a Traditional IRA because you won’t qualify for full tax deductions on your contributions. Go for a Roth.
I’m in the last category. I contribute to a Traditional 401(k) plan at work, and then contribute to a Roth IRA as well.
The Best Investments to Put in a Roth IRA
So, let’s say you decided to go with the Roth IRA option. What investments should you put in it?
Putting diversified index funds in is not a bad move. It’s the simplest method.
But it’s important to consider all of your accounts together. You might have a 401(k) at work, a Roth IRA, and a taxable brokerage account as well.
If you own domestic stocks, foreign stocks, bonds, and maybe some alternative assets, rather than spread them all equally in all of your accounts, you can get a better bang for your buck by prioritizing the least tax-efficient investments to put in your tax-free Roth IRA.
So, here’s a list of investments that a savvy investor might put into a Roth.
It doesn’t mean you should go out and accumulate all these types of investments; it just means that if you are interested in these investment strategies or already have these types of assets, the best place to stick them is in your Roth.
Real Estate Investment Trusts (REITs)
A normal company makes a profit, and gets taxed on that profit at the corporate level. They can use the remaining money to pay dividends and grow their business.
Investors then have to pay taxes on the dividends and capital gains they get from investing in shares of that company. Long-term capital gains and qualified dividends are taxed at a lower rate than ordinary income, though.
Currently the maximum rate is 20%, compared to almost 40% for ordinary income:
Source: Charles Schwab, using info from the IRS
Many people refer to this as “double taxation”, because the investors are the owners of the company, and they essentially pay tax once at the corporate level, and then pay more tax on their investment gains.
If you put those shares into a Roth IRA, you can skip the capital gains and dividend taxes, but the companies you own are still paying corporate taxes, which negatively affects their growth rates and the amount of money they can afford to pay in dividends.
REITs are different. They don’t pay any income taxes at the company level, but have to pay 90% or more of their income as dividends. That almost sounds too good to be true, but there’s a catch. Unlike normal qualified dividends that companies pay, these dividends are mostly taxed at the higher ordinary income tax rate. That’s how the tax man makes up for it.
But you can legally “cheat” the tax man by holding REITs in your Roth IRA. If you do that, your REITs aren’t paying any taxes on the company level, and you aren’t paying any of those high taxes on your dividends either. It’s a truly tax-free investment.
By not paying taxes at the trust level, REITs can grow more quickly than normal. And by not paying the “gotcha” higher-taxed REIT dividends, investors get to truly skip the tax bill.
That’s why REITs are the #1 investment for a Roth IRA.
You can either hand-pick certain REITs, or you can invest in Vanguard’s low-cost indexed REIT ETF, ticker VNQ.
Options are complex, and most people shouldn’t invest in them.
However, for hands-on investors, options can give you extra flexibility and income.
When most people think of options, they think of stupid high-leverage speculative strategies. The truth is that options can also be used to reduce risk and generate more investment income than normal stock investing.
For more information, I have articles on covered call options and cash-secured put options that give a detailed overview. These two option strategies are technically lower-risk than buying stocks normally, and are very income-focused.
I also have an article about using options with precious metals, where you can generate income from gold and silver ETFs for a small part of your portfolio if you want more diversification than just the typical stocks and bonds.
These option strategies have certain downsides of course, and the single biggest downside is that they are usually not very tax-efficient.
Option premiums of unexercised options are considered short-term capital gains, and thus taxed at the high ordinary income tax rate.
The way around that is, if you happen to use option strategies as part of your portfolio diversification, to stick them in your Roth IRA. Get the benefits of options without any of the tax-inefficiencies associated with these strategies.
This one is simple. The interest you receive from corporate bonds is taxed at your ordinary income tax rate, which is higher than the long-term capital gains and qualified dividends tax rate.
So if you’ve got a big pile of corporate bonds, stick’em in your Roth.
For similar reasons as corporate bonds, peer-to-peer lending, like through Lending Club, is a good investment strategy but not very tax efficient. The interest income generated from your lending notes is taxed at your high ordinary tax rate.
Some of the big platforms, like Lending Club, allow you to set up a Roth IRA to invest in them tax-free.
Real Estate Crowdsourcing
When you invest in a real estate crowdsourcing platform like Fundrise, you typically get a lot of distributions that, much like REITs, are taxed at high ordinary income tax rates.
Like Lending Club, some of these real-estate crowdsourcing platforms work with financial firms to allow you to open a Roth IRA to invest in real estate and avoid the onerous high ordinary tax rates.
The Worst Investments to Put in a Roth IRA
Some investments are inherently very tax-efficient, or even tax-free.
Therefore, if you have a Roth IRA and a separate taxable account, it makes sense to keep them in your taxable accounts and fill your Roth with your least tax-efficient investments.
Master Limited Partnerships (MLPs)
MLPs let you invest in natural resources and infrastructure, like natural gas pipelines that give off steady distribution payments.
MLPs have very complex tax consequences, and require you to fill out an extra tax form. However, despite the complexity, they are usually very tax-efficient for three reasons:
- MLPs are pass-through entities, like REITs.
- MLPs write off a lot of taxable income in the form of depreciation.
- MLP distributions are tax-advantaged, unlike REIT dividends.
When you receive MLP distributions, rather than being treated like a dividend that you have to pay taxes on, they reduce the cost basis in your investment.
Due to this, a lot of the tax on MLPs is deferred until you sell your investment, at which point it triggers a big taxable capital gain. Deferring taxes years or even decades is incredibly valuable, because all that time you get to keep compounding the money before having to give it to the government.
Furthermore, if you die and leave your MLP units to your descendants, the cost basis gets re-adjusted back up to the current price, and all those deferred capital gains are wiped out. This is a more powerful tax advantage compared to what happens when normal stocks are left to descendants.
All-in-all, these are very tax-efficient investments, and it’s usually best not to fill your Roth IRA with them.
Worse yet, sometimes MLPs generate unrelated business taxable income (UBTI), which needs to be taxed differently than their normal tax-advantaged income. If a Roth IRA generates more than $1,000 in UBTI in a given year, it has to report and pay taxes on it, despite being a tax-free account.
It’s not always a terrible choice to put MLPs in a Roth, though. If you have an MLP that has a good track record of not generating UBTI, and you’re more concerned about avoiding the tax complexities of owning an MLP than you are with tax optimization, then putting one in your Roth isn’t the end of the world.
The biggest advantage of municipal bonds is that they are tax-free.
So, if you put them in a Roth IRA, you aren’t getting any benefit, and they’re taking up valuable space that you could be putting your less tax-efficient investments in.
Foreign Dividend Stocks
Many countries withhold dividend taxes from foreign investors.
If you’re an American that receives dividends from an American corporation, they pay you the full dividend, and then depending on if it’s in a taxable or retirement account, reporting that dividend income and paying appropriate taxes is your responsibility.
However, foreign countries know that if you as an American owe, say, the government of France $195.83 in dividend taxes due to your investment in a French company, they aren’t realistically going to get that money from you.
So, they make the companies withhold that tax up front; they keep a percentage of it (often over 20%) and send you the rest, so you don’t have to worry about paying foreign taxes. Then, to avoid paying double taxation, the U.S. government lets you have a tax credit, so you don’t have to pay American tax on those foreign dividends.
A problem arises if you hold these foreign stocks in your Roth IRA. The foreign countries withhold their dividend taxes anyway, because they don’t care if your shares are in a U.S. retirement account or not. And you can’t get a U.S. tax credit to get these taxes back in your Roth. In other words, you end up paying foreign dividend taxes even though it’s supposed to be a tax-free Roth IRA.
Canada is an exception; due to treaties between the U.S. and Canada, Canada will not withhold dividend taxes from your shares in a Roth. Holding Canadian dividend stocks in your Roth is therefore perfectly optimal.
Fore more info on the specific foreign tax withhold rates of various countries, see this article by Brian Bollinger, CPA.
All-in-all, it’s not a terrible idea to own foreign stocks in a Roth IRA, because nothing really bad happens. But, you end up paying some taxes on them in many cases, and therefore don’t get the full benefits of a Roth IRA. It’s better to fill your Roth with investments that get the maximum benefit from the tax-free status of the account.
Opening a Roth IRA is usually an awesome move, especially if you already have a retirement plan like a Traditional 401(k) at work and your MAGI is below the income limit.
If that’s the case, the simplicity and employer-independent nature of this tax-free type of account works wonders, as long as you put the right types of investments in it.
If you put in $5,500 put year, and continue to put in an inflation-adjusted $5,500 per year (since the government occasionally increases the limit to keep up with inflation), your Roth IRA would grow like this based on rate of return and time:
The values in that table are inflation-adjusted to today’s dollars.
By investing each year like clockwork, you can eventually build several hundred thousand dollars in your Roth, in addition to the money in your 401(k) and other accounts.