The U.S. retirement landscape offers investors a plethora of accounts with which to optimize their investments. Notable among them is the Roth IRA, where investors make after-tax contributions in exchange for tax-free future withdrawals.
“Roth IRAs have several advantages, such as tax-free growth, tax-free withdrawals in retirement and the ability to pass a Roth IRA on to your beneficiaries with withdrawals being tax-free,” says Lauren Wybar, senior wealth advisor at Vanguard Personal Advisor Services. Thanks to these benefits, the net returns of investments held inside a Roth IRA tend to be higher than equivalent ones held in taxable brokerage accounts.
Asset selection and allocation are important considerations when optimizing a Roth IRA. This is the process of how investors pick which investments to buy and where to hold them. Because different investments have varying degrees of risk, expected returns and tax efficiency, smart asset selection and allocation can help investors produce better results.
“Generally, investors should allocate funds that are inherently less tax-efficient in a Roth IRA,” Wybar says. “For example, taxable bonds and real estate investment trusts make regular income payments, and actively managed stock funds are more likely to distribute taxable capital gains. By holding these investments in a Roth IRA, investors can avoid immediate tax burdens.”
With these broad considerations in mind, here are seven of the best funds to hold in a Roth IRA:
— Vanguard Target Retirement 2060 Fund (ticker: VTTSX)
— Vanguard Short-Term Inflation-Protected Securities ETF (VTIP)
— DFA US Small Cap Value Portfolio I (DFSVX)
— Schwab U.S. Dividend Equity ETF (SCHD)
— iShares Core US REIT ETF (USRT)
— SPDR Bloomberg High Yield Bond ETF (JNK)
— Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC)
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Vanguard Target Retirement 2060 Fund (VTTSX)
Because withdrawals from a Roth IRA can only be made after age 59 and a half without incurring a penalty, this account should be best used to hold long-term, retirement-oriented investments. A great solution here is a target-date fund, which allows investors to keep their holdings simplified.
Michael Ashley Schulman, partner and chief investment officer at Running Point Capital, likes target-date funds, noting that they offer the convenience of putting your portfolio rebalancing on autopilot. “The asset allocation of these funds will gradually shift to become more conservative as your target date for retirement or withdrawing the money approaches,” he says.
A suitable target-date fund for investors in their mid-20s looking to retire around 2060 is VTTSX, which currently holds a globally diversified portfolio of approximately 90% stocks and 10% bonds. The fund requires a $1,000 minimum investment and has a 0.08% expense ratio.
Vanguard Short-Term Inflation-Protected Securities ETF (VTIP)
The rising-interest-rate, high-inflation macroeconomic environment of 2022 showed the merits of an allocation to Treasury inflation-protected securities, or TIPS. The prices of these bonds are indexed to inflation, which can help offset some of its negative effects.
Anessa Custovic, chief investment officer at Cardinal Retirement Planning, says TIPS are best held in a Roth IRA. “The value of TIPS are readjusted annually until maturity, and you must pay taxes every time there is a readjustment. Thus, the tax burden they produce annually is a big drawback,” Custovic says.
An exchange-traded fund like VTIP is a great way of accessing TIPS with minimal interest rate sensitivity in a Roth IRA. This ETF holds a portfolio of short-term TIPS with an average maturity of 2.5 years, and it currently pays a yield-to-maturity of 4.2%. VTIP has a low expense ratio of 0.04%
[SEE: 7 Stocks That Are Good Inflation Investments]
DFA US Small Cap Value Portfolio I (DFSVX)
As noted, a Roth IRA’s primary benefit stems from the tax-free growth of assets held within it. To take advantage of these benefits, investors should adopt a long-term growth mindset. This usually takes the form of high equity allocations, but there are ways to optimize further.
“You’ll want to hold assets in a Roth that are expected to outperform your other holdings over the long term,” says Allen Mueller, founder and financial planner at 7 Saturdays Financial. Mueller suggests small-cap value stocks, which have been found to produce higher-than-expected investment outcomes.
A great way to invest in small-cap value equities is via funds like DFSVX. DFSVX is operated by Dimensional Fund Advisors, a firm with a history of successful factor investing. Over the trailing 10 years, DFSVX has returned an annualized 10%, beating the Russell 2000 Value Index, which returned 8.5%.
[SEE: 7 of the Best Long-Term Stocks to Buy.]
Schwab U.S. Dividend Equity ETF (SCHD)
Dividend investing is a popular strategy among U.S. investors, but it can be a hassle outside of a Roth IRA. In a taxable brokerage account, investors must pay taxes on dividends and keep track of their adjusted cost basis if they are enrolled in a dividend reinvestment plan.
“High-yield funds that pay out dividends at a higher rate than a vanilla index fund are great candidates for a Roth IRA,” says Kaleb Paddock, founder and certified financial planner at Ten Talents Financial Planning. “In a taxable account, these funds can incur a significant tax drag on their yield,” he says.
SCHD, a popular U.S. dividend ETF, tracks the Dow Jones U.S. Dividend 100 Index. Unlike some dividend ETFs, SCHD screens its holdings for sustainability of dividends and fundamental strength based on financial ratios. The ETF has a 30-day SEC yield of 3.3% and costs 0.06%.
iShares Core US REIT ETF (USRT)
Real estate investment trusts are a favorite asset class among income-oriented investors and those seeking real estate exposure. Many investors purchase REITs for their high income potential, but they can be rather tax-inefficient.
“In a Roth IRA, REIT funds are great holdings for taking advantage of the comparatively high tax-free distributions,” Paddock says. “In addition, you also benefit from price appreciation given the historically strong returns REIT investing and the real estate sector have provided,” he says.
A great ETF to invest in a diversified portfolio of U.S. REITs is USRT, which holds Prologis REIT Inc. (PLD), Equinix REIT Inc. (EQIX), Public Storage REIT (PSA) and Realty Income REIT Corp. (O), to name a few. The ETF costs 0.08% and currently pays a 30-day SEC yield of 3.3%.
[See: 7 Best REITs to Buy for a Recession]
SPDR Bloomberg High Yield Bond ETF (JNK)
One of the most tax-inefficient types of fixed income is high-yield bonds, also known as “junk bonds.” These are non-investment grade bonds with credit ratings below BBB, per Standard & Poor’s. Due to their risk, these bonds tend to pay much higher yields than Treasury or investment-grade bonds.
Corporate bond income is already heavily taxed, and the higher yield of junk bonds only adds to this tax burden. Thus, a Roth IRA is an ideal account to hold these high-yielding investments. The income from high-yield bonds will no longer be taxed in this account.
Investors can use ETFs like JNK to access high-yield bonds. This ETF tracks the Bloomberg High Yield Very Liquid Index and currently offers an average yield-to-maturity of 8.1% with a relatively short duration of 3.8 years, giving it lower interest rate sensitivity. JNK has an expense ratio of 0.4%.
Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC)
Some advanced investors like adding alternative asset classes to the usual portfolio of stocks, bonds and cash. Commodities can provide diversification benefits thanks to their low correlation with stocks and bonds and resistance to inflation.
However, many commodities funds rely on futures contracts for exposure. This causes them to spit out high year-end distributions that are taxed as ordinary income. In a taxable account, this can cause significant drag. Therefore, they are best held in a Roth IRA.
ETFs like PDBC offer a transparent way to invest in commodities. This ETF holds a basket of futures contracts tracking 14 energy, precious metals, base metals and agriculture commodities. PDBC charges a 0.62% expense ratio and does not require a Schedule K-1 form to be filed annually.
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7 Best Funds to Hold in a Roth IRA originally appeared on usnews.com
