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.