Investors often focus on the theoretical expected returns from their investments, but a crucial aspect that’s frequently overlooked is the impact of taxes on these returns. The historical averages posted by funds are usually presented first on a pretax basis, and the actual net returns received by investors can be significantly different once taxes are factored in.
Take, for example, Vanguard 500 Index Fund Admiral Shares (ticker: VFIAX), a mutual fund comprising large-cap U.S. stocks. This fund returned an annualized 12% before taxes over the past 10 years as of Dec. 31, 2023.
However, after accounting for taxes, this return was reduced to 11.5%. While this might seem like a small difference, over long periods the compounded impact can create a substantial gap in wealth accumulation.
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The tax impact can be even more pronounced for investments that are less tax-efficient than large-cap U.S. stocks. Real estate investment trusts, or REITs, foreign stock funds and bonds, for instance, may face higher tax rates on their distributions.
This is where asset location, or the strategic placement of different types of investments in various accounts, becomes crucial. A key tool in this strategy is the Roth IRA.
“A Roth IRA is an account that you can contribute after-tax contributions to, with investment returns, income and dividends growing tax-deferred,” says Scott Krase, wealth manager at Connor & Gallagher OneSource.
In 2024, the contribution limit for a Roth IRA is $7,000, with an additional $1,000 catch-up contribution allowed for those 50 and older. Eligibility for contributing to a Roth IRA is based on modified adjusted gross income, or MAGI, thresholds; single filers making less than $146,000 and joint filers making less than $230,000 can qualify for the full contribution.
The main benefits of a Roth IRA include tax-free growth on dividends, capital gains and income within the account, and withdrawals can be made without penalty after age 59 1/2, provided the account has been open for at least five years.
“Roth IRAs are an attractive financial savings vehicle because investors can contribute to them regardless of age and take advantage of tax-free income in retirement, with no required minimum distribution, unlike a traditional IRA, which requires distributions at age 73,” says Tiana Patillo, financial advisor manager at Vanguard.
These features make Roth IRAs an ideal location for holding less tax-efficient investments, helping investors maximize their after-tax returns and achieve their financial goals more effectively.
Here are seven of the best mutual funds and exchange-traded funds, or ETFs, to hold in a Roth IRA:
| Fund | Expense ratio |
| Vanguard Total World Stock Index Fund Admiral Shares (VTWAX) | 0.1% |
| Avantis All Equity Markets ETF (AVGE) | 0.23% |
| Vanguard Wellesley Income Fund Investor Shares (VWINX) | 0.23% |
| Invesco Nasdaq 100 ETF (QQQM) | 0.15% |
| iShares Morningstar Multi-Asset Income ETF (IYLD) | 0.6% |
| Schwab U.S. REIT ETF (SCHH) | 0.07% |
| Fidelity Freedom Index 2060 Fund Investor Class (FDKLX) | 0.12% |
Vanguard Total World Stock Index Fund Admiral Shares (VTWAX)
“Roth IRAs are especially beneficial for younger investors because there is greater saving potential due to that tax-free compounding,” Patillo says. One of the easiest investment theses for young investors to bet on is the prospect of the global economy continuing to grow. That is, by investing in the global stock market in a passive manner, young investors can reap the benefits of predictable long-term returns.
To put this strategy in play, young investors can buy and hold VTWAX in a Roth IRA. This highly diversified mutual fund tracks the FTSE Global All Cap Index, which holds over 9,700 stocks split approximately 60% in the U.S. market, 30% in international developed markets and 10% in emerging markets, respectively. The fund requires a $3,000 minimum investment and charges a reasonable 0.1% expense ratio.
Avantis All Equity Markets ETF (AVGE)
Investors looking to outperform VTWAX can use factor ETFs like AVGE, which tilts toward companies with smaller sizes, lower valuations and profitability. “This combination implies these companies have a high discount rate embedded in their market price, and a high discount rate generally drives higher expected returns for investors,” says Ted Randall, senior portfolio manager at Avantis Investors.
AVGE’s composition resembles that of VTWAX, with allocations toward U.S., developed and emerging markets via underlying Avantis ETFs. However, it holds a higher weighting toward small-cap value ETFs. “Academic research shows that companies trading at low price multiples with good profitability are expected to outperform, and that this performance premium is greater within small caps,” Randall says. AVGE charges a 0.23% expense ratio.
Vanguard Wellesley Income Fund Investor Shares (VWINX)
“Generally, investors should allocate funds that are less tax-efficient in a Roth IRA,” says Lauren Wybar, senior wealth advisor at Vanguard. “For example, taxable bonds and REITs make regular income payments, and actively managed stock funds are more likely to distribute taxable capital gains.” A great example of an actively managed, income-oriented Vanguard fund suitable for a Roth IRA is VWINX.
VWINX is one of Vanguard’s oldest mutual funds, debuting in July 1970. This fund uses a conservative strategy of allocating one-third to dividend stocks and two-thirds to investment-grade bonds. Since inception, VWINX has returned an annualized 9.2%. With a 4.1% 30-day SEC yield, this fund is capable of meeting the 4% withdrawal rate suggested for retirees. It charges a 0.23% expense ratio.
Invesco Nasdaq 100 ETF (QQQM)
“If you are younger and retirement is still years away, consider allocating a good portion toward mutual funds or ETFs that focus on growth,” says Jim Penna, senior manager of retirement services at VectorVest Inc. “Historically, these investments have potential for higher growth over time that you will generally pay no taxes on when held in a Roth IRA.” A great example is QQQM, which tracks the Nasdaq-100 Index.
QQQM’s portfolio consists of the largest 100 non-financial-sector stocks traded on the Nasdaq exchange, which, practically speaking, translates to high technology sector exposure at around 50%. Over the past 10 years, the outperformance of mega-cap tech sector stocks has helped the ETF’s index achieve a 17.9% annualized return. QQQM charges a 0.15% expense ratio.
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iShares Morningstar Multi-Asset Income ETF (IYLD)
“To take advantage of the tax benefits, it is generally better to hold investments in your Roth IRA that would otherwise generate taxable income,” Penna says. “For example, stocks that pay dividends or generate capital gains, real estate investment trusts, or REITs, known for favorable dividend payouts, and high-yield bond funds also fit into this category.”
Retirees who rely on their Roth IRAs to generate tax-free income can use a multi-asset ETF like IYLD. This ETF holds all of the assets mentioned by Penna and more via underlying ETFs that provide exposure to global dividend stocks, preferred shares, high-yield bonds, investment-grade bonds and mortgage REITs. IYLD currently pays a 5.7% 30-day SEC yield and charges a 0.6% expense ratio.
Schwab U.S. REIT ETF (SCHH)
“In a Roth IRA, REIT funds are great holdings for taking advantage of the comparatively high tax-free distributions,” says Kaleb Paddock, founder and certified financial planner at Ten Talents Financial Planning. “In addition, you also benefit from price appreciation given the historically strong returns REIT investing and the real estate sector have provided.”
For exposure to real estate in a Roth IRA, investors can buy a REIT ETF like SCHH. This ETF passively tracks the Dow Jones Equity All REIT Capped Index, which excludes higher yielding but potentially more volatile mortgage REITs. At present, investors can expect a high 4% 30-day SEC yield from SCHH, with quarterly distributions. The ETF charges a low 0.07% expense ratio.
Fidelity Freedom Index 2060 Fund Investor Class (FDKLX)
Long-term investors looking for a hands-off, buy-and-hold investment for a Roth IRA can use a target-date fund like FDKLX. As its name suggests, this mutual fund is intended for investors who are looking to retire around 2060. It currently provides an all-in-one portfolio of 54% in U.S. stocks, 36% in international stocks and 10% in bonds for a 0.12% expense ratio, with no minimum investment requirements.
However, it’s crucial to note that FDKLX’s current asset allocation of 90% in stocks and 10% in bonds is not static. As a target-date fund, the composition of this mix will gradually shift over time. As the years go by and 2060 draws closer, FDKLX will shift to become more and more conservative by decreasing its stock allocation and increasing its bond and cash equivalents.
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7 Best Funds to Hold in a Roth IRA originally appeared on usnews.com
Update 01/22/24: This story was previously published at an earlier date and has been updated with new information.
