While predicting the future performance of investment funds can be challenging, assessing their tax implications offers a clearer perspective on potential net returns. Therefore, it’s essential to recognize the various ways taxes can affect your investments.
For example, when you sell fund units at a price higher than your purchase cost (also known as the cost basis), you’ll incur capital gains taxes.
These are either short term — taxed at the federal income tax rate if the assets are held for less than a year — or long term, which are lower if the assets are held for more than a year. Short-term gains can also be subject to state and local income taxes.
Funds often distribute periodic income as dividends or interest. The tax rates on these distributions vary, with qualified dividends taxed at the favorable long-term capital gains rate.
Dividends from certain entities like real estate investment trusts (REITs) or master limited partnerships (MLPs) may not qualify for this rate. Interest-income tax treatment also varies widely, with differing approaches for corporate bonds, Treasurys and municipal bonds.
Navigating these tax rules can be complex, but holding funds in a Roth IRA offers a solution that simplifies this aspect of investing.
“A Roth IRA is an account that you can contribute after-tax contributions to, with investment returns, income and dividends growing tax-deferred,” explains Scott Krase, a wealth manager at Connor & Gallagher OneSource.
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The benefits of a Roth IRA are considerable: investments grow tax-free, and withdrawals are also tax-free after the age of 59 1/2, as long as 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, a financial advisor manager at Vanguard.
But not every investor will qualify for a Roth IRA. To be eligible this year for the full contribution amount, individuals must earn a modified adjusted gross income lower than $146,000. For joint filers, the limit is higher, at $230,000.
Within those limits, investors can contribute up to $7,000, with an additional $1,000 permitted for those age 50 and older as a “catch-up” contribution allowance.
Here are seven of the best mutual funds and exchange-traded funds, or ETFs, to hold in a Roth IRA:
| Fund | Expense Ratio |
| Vanguard Wellesley Income Fund Investor Shares (ticker: VWINX) | 0.23% |
| Vanguard Dividend Growth Fund (VDIGX) | 0.30% |
| Avantis U.S. Small Cap Value ETF (AVUV) | 0.25% |
| Invesco S&P 500 GARP ETF (SPGP) | 0.34% |
| Invesco S&P 500 Equal Weight ETF (RSP) | 0.20% |
| Invesco Zacks Multi-Asset Income ETF (CVY) | 1.06% |
| Schwab U.S. Large-Cap Growth ETF (SCHG) | 0.04% |
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 real estate investment trusts, or REITs, make regular income payments, and actively managed stock funds are more likely to distribute taxable capital gains.” A great example is the income-focused VWINX.
This Vanguard mutual fund dates back to 1970 and offers a balance of capital preservation and income potential. It achieves both of these goals by allocating two-thirds of its portfolio to dividend stocks, while allocating one-third to investment-grade bonds. Investors who buy and hold VWINX can currently earn a 4.1% 30-day SEC yield, which is tax-free if held in a Roth IRA. VWINX charges a 0.23% expense ratio, or $23 annually for a $10,000 investment.
Vanguard Dividend Growth Fund (VDIGX)
“Roth IRAs are especially beneficial for younger investors because there is greater saving potential due to that tax-free compounding,” Patillo says. A great way to compound wealth long term is via the snowballing potential of dividend growth stocks. These companies have a historical record of growing payouts over time, which investors can reinvest steadily to accumulate more shares.
The Vanguard fund focused on this strategy is VDIGX. The focus of this fund is on quality companies that may not necessarily pay the highest yields but have both the history and potential to continually grow them. The fund pays a 1.7% 30-day SEC yield, which is higher than the broader market and thus makes it a great Roth IRA holding. The fund has a 0.3% expense ratio.
Avantis U.S. Small Cap Value ETF (AVUV)
Asides from tax-efficiency, investors can also use a Roth IRA to hold assets with higher expected returns. A great example of these are small-cap companies with lower valuations. “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.
To access a diversified portfolio of U.S. small-cap value stocks, consider AVUV. This ETF screens small-cap stocks based on price-to-book ratios and profitability-to-book ratios. Over the past three years, AVUV has outperformed its benchmark, the Russell 2000 Value Index, delivering an annualized return of 11% compared to the index’s 2.2%.
Invesco S&P 500 GARP ETF (SPGP)
For a large-cap alternative to AVUV that focuses more on quality, consider SPGP. “SPGP picks the 75 stocks in the S&P 500 that have demonstrated the highest composite of three-year trailing earnings-per-share and sales-per-share growth, with the highest earnings-to-price ratio, highest return on equity and lowest debt-to-equity ratio,” says Nick Kalivas, head of factor and core equity ETF strategy at Invesco.
This ETF selects 75 stocks from the broader S&P 500 based on growth scores and quality and value composite scores. The former is assessed based on three-year earnings and revenue per share, while quality and value are calculated via leverage ratio, return on equity and price-to-earnings ratios. The point of SPGP is to gain exposure to growth stocks, but without overpaying for them or compromising on quality.
Invesco S&P 500 Equal Weight ETF (RSP)
Equal-weight funds can be a great way for contrarian investors to avoid concentration risk. For example, the SPDR S&P 500 ETF (SPY) currently has about a 30% allocation to the technology sector, with the top-10 holdings accounting for around 33% of the ETF’s weight. Using an equal-weight fund like RSP can sidestep this, while holding it in a Roth IRA can mitigate the tax burden from its higher 1.8% 30-day SEC yield.
“RSP also provides investors an entrance into factor-based investing, as the process of equal weighting provides access to the small size factor and the quarterly rebalance provides access to the value factor,” Kalivas says. “Each quarter the fund trims companies that have risen above their equal-weight percentage and adds to stocks that have fallen below their equal-weight percentage.”
Invesco Zacks Multi-Asset Income ETF (CVY)
“To take advantage of the tax benefits, it is generally better to hold investments in your Roth IRA that would otherwise generate taxable income,” says Jim Penna, senior manager of retirement services at VectorVest Inc. “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 fit into this category.”
An income-oriented fund that ticks most of these boxes is CVY. This ETF holds dividend stocks, REITs, MLPs, preferred stock and even some closed-end funds. By doing so, it pays a fairly high but rather tax-inefficient 4.7% 30-day SEC yield. As such, it is best held inside a Roth IRA. Keep in mind that this ETF makes quarterly distributions, not monthly. It also charges a high 1.06% expense ratio.
Schwab U.S. Large-Cap Growth ETF (SCHG)
“If you are younger and retirement is still years away, consider allocating a good portion toward ETFs that focus on growth,” Penna says. “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 highly popular growth ETF to watch for this purpose is SCHG, which also charges a very affordable 0.04% expense ratio.
SCHG passively tracks the Dow Jones U.S. Large-Cap Growth Total Stock Market Index, which holds 250 of the largest domestic growth stocks. While it is tax-efficient with a 0.4% 30-day SEC yield, holding SCHG in a Roth IRA can have long-term benefits. By keeping SCHG in a Roth IRA until after age 59 1/2, investors can potentially cash out on large capital gains without paying taxes once withdrawals begin.
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7 Best Funds to Hold in a Roth IRA originally appeared on usnews.com
Update 04/16/24: This story was previously published at an earlier date and has been updated with new information.
