Understanding what is a Roth IRA is an important first step before deciding how to use one for retirement. A Roth IRA is a type of individual retirement account that can hold different investments while offering specific tax advantages. Unlike a regular savings account, a Roth IRA is designed primarily for long-term investing and retirement planning.
The investments you choose inside your Roth IRA can have a major effect on how your account grows over time. Fortunately, Roth IRAs can generally hold a wide range of investments, including stocks, bonds, mutual funds, exchange-traded funds, certificates of deposit, and certain other assets.
This guide explains the major investment choices available in a Roth IRA, how they work, and what investors should consider when choosing among them.
What Is a Roth IRA
Before discussing investments, it helps to understand what is a Roth IRA and why people use this type of retirement account.
A Roth IRA is a retirement account that allows eligible individuals to contribute money after paying applicable taxes on that income. The investments inside the account can potentially grow over many years.
One of the most important features is the potential for qualified withdrawals to be tax-free. Generally, qualified distributions from a Roth IRA are not subject to federal income tax when the applicable requirements are met.
Because of this structure, many people use Roth IRAs as long-term retirement investment accounts rather than simply keeping cash in them.
How Roth IRA Investing Works
Opening a Roth IRA does not automatically mean that your money is invested.
After making a contribution, you generally need to choose investments for the money. Depending on the financial institution, you may have access to stocks, ETFs, mutual funds, bonds, and other investment products.
This distinction is important. Someone could contribute money to a Roth IRA and leave it sitting in a settlement fund or cash position without purchasing investments.
For long-term retirement planning, investors often create a diversified portfolio based on their goals, time horizon, and tolerance for investment risk.
Stocks
Stocks are one of the most common investments that can be held inside a Roth IRA.
When you purchase shares of a company, you are buying a small ownership interest in that business. Stocks can potentially increase in value and may also pay dividends.
For investors with many years until retirement, stocks can provide significant long-term growth potential. However, stock prices can also fall sharply, sometimes for extended periods.
Individual Stocks
A Roth IRA can generally hold individual stocks that are available through the brokerage.
For example, an investor might purchase shares of companies in technology, healthcare, consumer goods, financial services, or other industries.
Individual stocks can provide substantial growth opportunities, but they also carry company-specific risk. If one company performs poorly, its stock price can decline significantly.
For this reason, investors should consider diversification rather than placing most of their retirement savings into only a few companies.
Exchange-Traded Funds
Exchange-traded funds, commonly called ETFs, are another popular investment that can be held in a Roth IRA.
An ETF is a fund that typically holds a collection of investments. Many ETFs are designed to follow a particular index, industry, market segment, or investment strategy.
For example, an ETF may track a broad U.S. stock market index. Instead of purchasing shares in dozens or hundreds of companies individually, an investor can buy shares of one fund that provides exposure to many securities.
Why Investors Use ETFs
ETFs can make diversification easier.
A single broad-market ETF may contain hundreds or even thousands of companies. This can reduce the impact that one company's poor performance has on the overall portfolio.
ETFs can also have relatively low expenses, although costs vary between funds.
Investors should review a fund's expense ratio, holdings, investment strategy, and risk before purchasing it.
Mutual Funds
Mutual funds can also be held inside many Roth IRA accounts.
Like ETFs, mutual funds pool money from many investors and use that money to purchase a collection of securities.
Some mutual funds focus on stocks, while others invest in bonds, international markets, specific industries, or combinations of investments.
Index Mutual Funds
Index funds are designed to follow a particular market index rather than trying to select investments individually.
Because they generally follow a predetermined strategy, index funds can have relatively low management costs.
A broad-market index fund can provide exposure to many companies and may be useful for investors who want a simple, diversified approach.
Actively Managed Mutual Funds
Some mutual funds are actively managed. A professional fund manager or management team decides which securities the fund should buy and sell.
These funds may have higher expenses than some index funds because of their management structure.
Investors should compare expenses and historical performance while remembering that past performance does not guarantee future results.
Bonds
Bonds are another investment that may be held in a Roth IRA.
When an investor purchases a bond, they are generally lending money to a government, municipality, or company. In return, the bond may provide interest payments and repayment of principal according to its terms.
Bonds are often used to provide income and balance the risk of stocks.
Types of Bonds
Several types of bonds may be available through a brokerage account.
These can include U.S. government bonds, corporate bonds, municipal bonds, and bond funds.
The risk level varies considerably. Government securities may have different credit characteristics from corporate bonds, while longer-term bonds can be more sensitive to interest-rate changes.
A bond fund can provide exposure to many bonds rather than relying on one individual bond.
Certificates of Deposit
Some Roth IRA providers allow investors to hold certificates of deposit, commonly known as CDs.
A CD generally pays a predetermined interest rate for a specified period. Unlike stocks, its return is usually established in advance according to the terms of the CD.
CDs can be useful for investors who prioritize preservation of principal and predictable returns, although they generally have less growth potential than stocks over very long periods.
Investors should also consider inflation and the opportunity cost of holding money in lower-growth investments.
Money Market Investments
Roth IRA accounts can also have money market funds or similar cash-management investments, depending on the provider.
These investments are generally designed to provide stability and liquidity rather than aggressive long-term growth.
They can be useful for holding money temporarily before investing it or for maintaining a portion of a portfolio in lower-volatility assets.
However, keeping too much retirement money in cash for decades can limit potential growth.
Real Estate Investments
Some specialized Roth IRA arrangements can hold certain real estate investments.
This area is more complicated than purchasing a publicly traded stock or ETF. Certain investors may use self-directed IRAs to access alternative investments, including some forms of real estate.
However, strict rules apply.
The account owner generally cannot use retirement-account assets for personal benefit in ways prohibited by tax rules. Transactions involving the account owner and certain related parties can create serious tax consequences.
Because of these complexities, anyone considering real estate or other alternative assets inside a self-directed Roth IRA should understand the applicable rules and seek qualified professional guidance.
Other Alternative Investments
Depending on the account structure and provider, some Roth IRAs may be able to hold alternative assets.
Examples can include certain private investments, precious metals, or other specialized assets.
However, not every Roth IRA provider offers these options.
Alternative investments may also involve higher fees, lower liquidity, greater complexity, or additional risks.
An investor should carefully review the rules before putting retirement savings into an unfamiliar investment.
Investments a Roth IRA Generally Cannot Hold
Understanding prohibited investments is just as important as knowing what a Roth IRA can hold.
The tax rules place restrictions on certain types of assets and transactions.
For example, collectibles are generally restricted within IRAs. Certain forms of personal-use property and transactions involving disqualified persons can also create problems.
The exact rules can be complicated, particularly for self-directed accounts.
Investors should not assume that an investment is permitted simply because a company offers a way to place it inside an IRA.
Choosing Investments for a Roth IRA
Knowing what is a Roth IRA does not automatically tell you which investments are appropriate. Investment selection depends on several personal factors.
Consider Your Time Horizon
Your time horizon is the amount of time before you expect to need the money.
A person who is decades away from retirement may have more time to recover from temporary market declines than someone approaching retirement.
A longer time horizon can allow investors to consider investments with greater growth potential, although risk still needs to be understood.
Consider Risk Tolerance
Risk tolerance refers to how comfortable you are with investment losses and market fluctuations.
Stocks can experience significant declines. Bonds and cash investments may be less volatile in some circumstances but can have lower long-term growth potential.
Choosing an investment strategy that matches your ability and willingness to tolerate market changes can make it easier to stay invested during difficult periods.
Think About Diversification
Diversification means spreading investments across different assets, companies, industries, or markets.
For example, instead of investing everything in one company, an investor might hold a diversified combination of stock funds, bonds, and other investments.
Diversification cannot eliminate investment losses, but it can reduce the risk associated with depending heavily on one investment.
Roth IRA Investment Fees
Fees are another important consideration.
Investment costs can include expense ratios, trading costs, account fees, advisory fees, and other charges.
A fee that appears small can have a significant effect over several decades because money spent on fees is money that is not remaining invested.
When comparing funds, investors should review the expense ratio and understand exactly what services the fee covers.
Tax Advantages of Roth IRA Investments
One major reason people use Roth IRAs is the potential tax treatment of qualified withdrawals.
Contributions are made with money that has already been included in taxable income, subject to applicable rules. If the requirements for a qualified distribution are satisfied, withdrawals can generally be tax-free at the federal level.
The potential tax-free growth can make the account attractive for long-term retirement investing.
However, Roth IRA rules include requirements concerning contributions, withdrawals, income eligibility, and other factors. Tax rules can also change over time.
Building a Simple Roth IRA Portfolio
Investors do not necessarily need dozens of different investments to create a diversified portfolio.
A simple portfolio might use broad-market stock funds combined with bond funds, depending on the investor's circumstances.
Another investor might use several ETFs covering U.S. stocks, international stocks, and bonds.
The appropriate allocation depends on factors such as age, retirement timeline, financial goals, income, other retirement accounts, and risk tolerance.
Review Your Portfolio Regularly
Investing is not necessarily a one-time decision.
Over time, market movements can cause one part of a portfolio to become much larger than originally intended.
For example, if stocks rise significantly while bonds remain relatively stable, the percentage of the portfolio invested in stocks may increase.
Some investors periodically review and rebalance their portfolios to maintain their intended asset allocation.
Common Mistakes to Avoid
One common mistake is assuming that opening a Roth IRA means the money is automatically invested.
Another mistake is choosing investments without considering fees or diversification.
Some investors may also make decisions based entirely on recent performance. An investment that performed extremely well recently may not continue doing so.
It is also important to understand Roth IRA contribution and withdrawal rules. Taking action without understanding the tax consequences can create unnecessary problems.
Conclusion
Understanding what is a Roth IRA provides the foundation for making informed retirement decisions. A Roth IRA is not itself a single investment. Instead, it is a tax-advantaged retirement account that can contain various investments, depending on the provider and applicable rules.
Stocks, ETFs, mutual funds, bonds, CDs, and money market investments are among the common choices available to Roth IRA investors. Some specialized accounts may also provide access to alternative investments, although those options can involve additional restrictions and complexity.
The best portfolio structure depends on the individual investor. Time horizon, risk tolerance, diversification, fees, retirement goals, and existing investments all matter.
A Roth IRA can be especially valuable when used as part of a long-term strategy rather than as a place to make frequent speculative decisions. Investors should understand both the potential benefits and the risks associated with each investment before making decisions.
Most importantly, remember that the account and the investments are separate concepts. A Roth IRA provides the account structure and tax treatment, while the investments determine how the money is allocated and exposed to market risk.
For personalized tax or investment guidance, it can be useful to consult a qualified financial or tax professional who can consider your complete financial situation and the rules that apply to you.