A Roth IRA is a special type of individual retirement account created by the Taxpayer Relief Act of 1997. The biggest difference between a Roth IRA and other retirement accounts, such as a traditional IRA, is that you cannot deduct contributions to a Roth IRA on your taxes. Your qualified distributions, however, will be tax-free.
Because all IRAs grow tax-deferred, it means your investments in a Roth IRA are never taxed — you won’t pay tax annually on your gains and you won’t pay tax on your future distributions. To maximize your investment, make sure you know the Roth IRA rules and your investing options within this retirement account.
4 Options for Roth IRA Investments
Within your Roth IRA, you’ll find you have four general options for investing those funds. So you can better decide how to allocate your money, here are details on Roth IRA investment options:
1. Zero-Coupon Bonds
Zero-coupon bonds don’t pay you interest; instead, you get credited with regular interest but you won’t get it until the bonds reach maturity. Zero-coupon bonds, however are still among the best investments for a Roth IRA due to how they are taxed.
When you buy a zero-coupon bond, you typically pay significantly less than the maturity price. For example, you might pay $500 for a zero-coupon bond that matures in 20 years at $1,000. Your return is the amount the bond appreciated, which is $500 in this case.
The problem with holding zero-coupon bonds in a regular, taxable account is that you must pay taxes on the bond’s prorated increase in value every year, even though you don’t receive any cash distributions. For example, a 20-year, zero-coupon bond might earn you about $25 per year in accrued interest, which you’ll owe tax on — unless you own the bond in a Roth IRA.
Related: Should You Invest in a Roth IRA?
2. Short-Term Stock Trades
If you buy and hold stocks for the long haul, you won’t benefit much from holding them in a Roth IRA, at least from a tax perspective. Long-term capital gains are taxed at rates as low as 0 percent, so holding them in a taxable investment account makes sense.
If you’re a rapid-fire trader, however, a Roth IRA might be your best friend. Short-term stock gains — defined by the IRS as those held for one year or less — are taxed at ordinary income tax rates. As of 2017, this means your federal tax alone could hit 39.6 percent on short-term stock profits. If you make those trades in your Roth IRA, however, you won’t owe any tax at all.
3. High-Yield Bonds
Companies with below-average credit ratings issue high-yield bonds, also known as “junk” bonds. In exchange for a higher risk of default, these bonds typically pay higher interest rates. These bonds are risky because they have no guarantee other than the promise of the issuing company, which might default on the bonds if it hits rough financial times.
If you’re considering high-yield bonds you should probably hire a professional to manage this part of your portfolio. He can help you diversify your investment allocation, which will protect you from a total loss if one high-yield issuer defaults. Although high-yield bonds are more aggressive, if they match your risk tolerance and investment objectives, they might be a good option for a Roth IRA because you won’t be taxed on the interest they pay.
Related: A Beginner’s Guide to Roth IRAs
4. Mortgage-Backed Securities
A mortgage-backed security is an asset-backed security typically secured by a collection of mortgages. When homeowners pay their mortgages, the payments go to investors in the form of interest payments. As you pay your mortgage principal down, that money also goes to investors in the form of principal payments.
Government National Mortgage Association bonds are generally appropriate for conservative investors because their interest and principals are backed by the “full faith and credit of the U.S. government.” Because interest is subject to both federal and state tax, however, shielding this income in a Roth IRA makes sense. Note that although you can buy GNMA securities in the secondary market from a broker, you can buy new GNMA bonds for a minimum denomination of $25,000.
Choose Your Roth IRA Investments Wisely
You can choose almost any type of investments for your Roth IRA, so choose ones that match your investment objectives and risk tolerance — and have the best chance of becoming profitable. Putting investments that are subject to the highest amount of tax in your Roth IRA is generally a good retirement planning strategy, but make sure you never invest in a security only for tax reasons.
Learn More: How to Find the Best Roth IRA