Saving for retirement is one of the most important things you can do to prepare for your financial future. Roth IRAs are a special type of investment account that help people build their retirement nest eggs. In exchange for limiting their ability to make withdrawals, Roth IRAs let investments grow tax-free and let you withdraw that money in retirement without paying taxes.
In order to get the most out of your Roth IRA, you need to know the best way to invest in the account. Here are some tips to make sure that you can get the greatest benefit from this type of account.
Key Takeaways
- Roth IRA contributions are made with after-tax money, unlike contributions to a traditional IRA or 401(k)
- Money in a Roth IRA grows tax-free and no tax is paid on earnings when withdrawn if rules are followed
- Younger investors could consider starting with growth stocks and shift investments to a more conservative strategy near retirement
Avoid Tax-Friendly Investments
Roth IRAs are funded with after-tax dollars and your investments can grow tax-free. You don’t have to pay taxes on dividends, capital gains, or anything else that happens in your Roth IRA if your withdrawals follow the rules.
What that means is that you do not need to worry about tax-efficient investments when you’re using a Roth IRA. Some investors choose to invest in products like municipal bonds because they are more tax-efficient than other investments. Such tax-efficient investments may have a slightly lower return on investment.
Roth IRAs give investors more freedom to choose investments that have higher potential returns and avoid the high tax burden those investments may otherwise carry in taxable accounts.
Use Growth Stocks in Early Years
Saving for retirement is a marathon rather than a sprint. If you start investing at age 25, you have about 40 years until you reach normal retirement age of 65. That long time horizon means that you have plenty of time for your investments to gain value before you need to rely on them for retirement income.
Starting young also has a couple of other advantages. Younger investors, typically, have a greater appetite to take risks and the ability to weather market volatility.
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Growth stocks are stocks with higher risk, but more potential to gain value over time.
Typical characteristics of growth stocks are those with smaller market caps but growing earnings and a lack of dividend payments as the company invests profits back into the business.
Using growth stocks you could maximize the benefit of using a Roth IRA because not only can it grow your portfolio significantly and all the capital gain would be tax-free if the withdrawals meet certain criteria.
The fact that early withdrawals from Roth IRAs are discouraged with penalties until you reach retirement age also means that you don’t need to touch your investments to serve as a source of cash flow.
You can also invest in growth stocks using growth mutual funds and exchange-traded funds (ETFs).
Shift Your Investment Strategy as You Age
As you get older and closer to retirement, you’ll likely want to reduce the risk of your portfolio.
Market volatility can diminish the value of your portfolio and down years closer to your retirement can have a major impact on whether your nest eggs last long enough as you begin to make withdrawals. This is called sequence of returns risk and it is one of the biggest risks facing withdrawals.
Shifting your Roth IRA into less risky stocks or dividend-paying stocks could reduce the volatility in your portfolio.
Selecting a mix of relatively less risky stocks and exposure to dividend and income ETFs could be a good way to shift the focus of your portfolio as you near retirement.
How To Find the Best Stocks for Your Roth IRA
If you’ve decided to open a Roth IRA, you’ll want to find the best stocks to buy in the account.
One good way to find investment opportunities is to use a stock screening tool. These tools let you search for stocks based on factors such as the company’s market capitalization, industry, various technical analysis indicators, and other factors.
While you’re young, you can use a screener to search for growth stocks that have the potential to gain significant value. As you get closer to retirement, you can use a screener to find value investments, which tend to have low price-to-earnings ratios and be less volatile. You can also screen for things like high dividend yields, which increase the amount of income your portfolio can produce.
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A good place to start while looking for dividend stocks could be companies that have a long history of dividend payouts. Dividend aristocrats are companies with over 25 years of dividend payout history.
Choosing the right stocks to invest in can be difficult. One of the best ways to help your portfolio succeed is to make sure you own a diversified selection of stocks and other securities. This can reduce your portfolio’s volatility.
Frequently Asked Questions (FAQs)
How do I buy stocks with a Roth IRA?
You can open a Roth IRA with almost any brokerage company. Once you’ve opened an account, you can buy stocks by submitting a buy order through your broker. You’ll outline the number of shares to purchase and your broker will buy the shares on your behalf.
What happens if I sell stocks I held in my Roth IRA?
If you sell stocks in your Roth IRA, the proceeds from the sale will be deposited to your Roth IRA’s sweep account. There are no taxes to pay because the account is tax-sheltered. You can then use the money from the sale to purchase other investments.
How long do stocks have to be held in a Roth IRA?
There is no minimum length of time you must hold stocks in a Roth IRA. However, you would be penalized or need to pay additional taxes if you withdraw money from the account until you turn 59½ or the account has been open for less than five years.