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The Right Way to Invest Your Roth

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Regardless of whether you're converting your traditional retirement accounts to a Roth IRA for the first time or have had a Roth for years, opening the account is only the first step toward success. Unless you set up your investments to take maximum advantage of your Roth, you'll probably be disappointed with your eventual results -- and your entire decision-making process behind choosing to convert in the first place may prove to have been flawed.

Your goals for a Roth
The first thing to realize about investing your Roth assets is that a Roth IRA is just one tool in your investing arsenal. You have to put your Roth in the overall context of your entire portfolio. For instance:

  • Young investors might well have the bulk of their savings in a Roth. They can afford to invest aggressively, but they also don't have much ballast outside their Roth account to counterbalance the Roth's swings.
  • Investors closer to retirement likely have a mix of investments spread across taxable accounts, traditional retirement accounts, and Roth IRAs. Even though they may want to take a more conservative approach with their portfolio as a whole, they may still be able to focus their most aggressive investments within their Roth IRAs.

In addition, you need to consider your temperament as an investor. Someone who buys and holds stocks over periods of decades will want to use a different strategy than someone who rarely holds a stock for more than a year.

Some rules of thumb
Nevertheless, there are some general observations that hold true for many investors. The assets you'll want to buy with your Roth IRA money should have a combination of these traits:

  • First, they should have the highest growth potential.
  • Second, they should benefit the most from avoiding taxes on income and capital gains.
  • Finally, if you're converting from a traditional IRA, you can take some of your most aggressive risks in your Roth, knowing that you can recharacterize them and get some tax benefit from your losses while potentially reaping great rewards if things work out well.

In the pantheon of investments, then, perhaps the most appropriate for IRAs are high-yielding assets whose income doesn't qualify for preferential tax rates. That means if you're inclined to invest in high-yield corporate bonds from issuers like MBIA (NYSE: MBI  ) , Zions Bancorp (Nasdaq: ZION  ) , and Radian Group (NYSE: RDN  ) , they might fit extremely well in a Roth. The same goes for high-yielding REITs like Annaly Capital (NYSE: NLY  ) and HCP (NYSE: HCP  ) .

At first glance, master limited partnerships, such as Kinder Morgan Energy (NYSE: KMP  ) and Enterprise Products Partners (NYSE: EPD  ) , might seem to be a good addition to this list. But because of some of the tax complexities involved with MLPs, they aren't as valuable in IRAs as other assets.

How about stocks?
Of course, people tend to have a lot more of their money in stocks than in the alternatives listed above. It's fine to have stocks in a Roth IRA, but they don't give you quite as much benefit from tax avoidance.

The reason is that right now, long-term capital gains and qualified dividends are taxed at a maximum rate of 15%. So you don't save as much in taxes from having stocks in a Roth if you're a long-term investor. But given that stocks give you the opportunity for huge profits, having the right stock in a Roth could create big tax savings. In addition, there's no guarantee how long that 15% rate will last.

Moreover, if you trade somewhat more frequently, you'll find the Roth gives you a lot of flexibility. You won't have to worry about higher short-term capital gains taxes, and the complicated rules that can nullify qualified dividend treatment become a moot point as well.

Even if the tax benefits aren't quite as great, a converted Roth IRA is a great place to take some bets. If things go well, then you'll pocket a big gain free of tax. If things go poorly, you can recharacterize back to a traditional IRA and avoid having to pay the taxes on your conversion.

Take a look
Over the past week, we've talked about a number of ways in which a Roth IRA can fit into your overall financial plan. Although Roths aren't right for everyone, the new opportunity everyone has to get into a Roth makes it worth the time to take a closer look. You may well find that a Roth is the perfect complement to the financial plan you already have for your retirement and beyond.

This article concludes Dan's week-long series on Roth IRAs, but he'll be revisiting the topic throughout the coming months. So if you have questions or comments about Roth IRAs, pipe up in the comment section below. Dan can't give specific investment advice, but general questions can help others in a similar situation.

Fool contributor Dan Caplinger is one of those weirdos who can't get enough of talking about tax savings. He doesn't own shares of the companies mentioned in this article. Enterprise Products Partners is a Motley Fool Income Investor selection. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy always points you in the right direction.


Read/Post Comments (10) | Recommend This Article (27)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 08, 2010, at 3:31 PM, liketheking wrote:

    Is the government going to take your ROTH and invest it into T-Bills to cover itself?

    That's what I get from this article from BusinesWeek.

    http://www.businessweek.com/news/2010-01-08/americans-oppose...

  • Report this Comment On January 08, 2010, at 4:54 PM, Classof1964 wrote:

    Please be more explicit in why MLPs would not be as valuable in a Roth IRA as other investments. In fact, if a MLP like EPD were in a Roth, and the return of capital were not reinvested so that all one's investment was returned, would one not be free of taxes on the continuing payments (though technically there was no more of my capital in the investment? If not in a Roth, in such circumstances the IRS considers any money returned after the basis is zero, taxable in that year. If one is a buy and hold investor, if I am right about this scenario, it seems like a very good place for a MLP.

  • Report this Comment On January 08, 2010, at 9:48 PM, edyboom223 wrote:

    MLPs are better in taxable accounts. Sorry I can't help you more, but I've read about it before. I believe that if you hold them in IRAs and make a certain amount a year that you have to pay for the profits. The reason is that you are receiving earnings and not dividends...something like that. Sorry I can't be of more assistance.

  • Report this Comment On January 08, 2010, at 9:48 PM, edyboom223 wrote:

    MLPs are better in taxable accounts. Sorry I can't help you more, but I've read about it before. I believe that if you hold them in IRAs and make a certain amount a year that you have to pay for the profits. The reason is that you are receiving earnings and not dividends...something like that. Sorry I can't be of more assistance.

  • Report this Comment On January 11, 2010, at 7:13 AM, jfp43 wrote:

    I've not noticed anyone commenting on the 5 year period your Roth has to be in force prior to withdrawal of any funds without penalty. For persons near retirement this could be a killer if faced with unexpected expenses requiring use of that money.

  • Report this Comment On January 13, 2010, at 12:51 AM, prginww wrote:

    I have to agree with Classof1964's comments - more clarity is needed on why MLPs are a tax problem in a Roth IRA.

    We need granularity on this. There is a reasonable argument that tax complications could exist in a standard IRA when such funds are withdrawn from such an IRA but why would that complexity carry over into a Roth IRA. Do you have a reference to an IRS publication?

    Also, it would seem that an MLP derivative ETN such as JP Morgan's 'AMJ' solves any tax issues as they deliver a 1099 and there is no K-1 record keeping required.

    If you're going to write about Roths and MLPs, please be more specific. The column is incomplete.

  • Report this Comment On January 13, 2010, at 5:00 AM, blesto wrote:

    Here's a good discussion on the Dividend Growth Investing board that may answer some questions about MLP's

    http://boards.fool.com/Message.asp?mid=28216220&sort=who...

    Hope that helps.

  • Report this Comment On January 13, 2010, at 10:27 PM, boger1 wrote:

    willneed

    interesting point on the ETN. I hadn't considered that. The reason MLPs are dangerous in tax-deferred accts is that they are essentially returning earnings and not paying dividends. You (or your accountant) may have to do some pretty fancy calculation come tax time because of this. I think it relates to the overall size of the account and the percentage that the MLP makes up...

    and to jfp43...any money rolled over into a Roth is TAXED, thus it becomes "principal" and not earnings. So it can be immediately withdrawn. The advantage to the Roth is that you can withdraw as much or as little as you wish, tax-exempt, because no RMDs are required in Roth accounts.

  • Report this Comment On January 13, 2010, at 10:35 PM, boger1 wrote:

    Blesto

    Excellent link, and there is another link contained on that page that explains UBIT in greater detail.

    http://www.naptp.org/PTP101/MLPs_Retirement_Accounts.htm

    It is important to note that the $1,000 limit on UBI does NOT mean you are limited to $1,000 in distributions from the MLPs; the K-1 forms will tell you how much is Unrelated Business Income. You must then tally the amounts across all MLPs in which you invest to get the total. Also, you aren't responsible for the taxes directly; the custodian of the 401K/IRA is responsible (i.e., the broker). They pay the taxes out of your invested funds via a 990 form. Whew!

  • Report this Comment On January 14, 2010, at 11:19 PM, rick1138 wrote:

    I wish that whenever someone talks about MLPs and recommends KMP, but warns about the "tax complexity" for retirement accounts, they ignore the KMR shares which are the same (or nearly so) as the KMP shares. The KMR "dividend" is paid as essentially a share split which does not incur any issues with K-1s and UBTI. Another advantage is that the KMR shares trade at a slight discount to KMP, thus the dividend yield (paid as shares) is higher for KMR

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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