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The Best Buys for Your Roth IRA

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In the battle for a comfortable retirement, you have to make sure you have the right weapon at your side. Although traditional IRAs have been around for a lot longer, a Roth IRA could do even more toward getting you the retirement of your dreams.

On Monday, I showed you how you could stiff-arm the IRS and save your way to a comfortable retirement. But as a number of readers pointed out, when it comes to picking retirement accounts, you have more than one type of IRA at your disposal. If you haven't already looked into opening a Roth IRA, there's no better time than now. Below, you'll find ideas on how to invest your money once you get it into a Roth account.

IRA benefits magnified
Opening an IRA can be the biggest step forward you'll ever take toward retiring rich. Traditional IRAs give you a nice combination of current and future benefits: You get an upfront deduction on your current-year tax return, and you also get tax deferral for as long as you can keep your money inside your IRA.

But Roth IRAs bring a benefit that's potentially worth a whole lot more. In exchange for giving up the upfront tax deduction you get with a traditional retirement account, Roth IRAs give you true tax-free growth. Even after you start taking money out of your Roth to use in retirement, you still don't have to include your withdrawals on your tax return -- and you'll never pay a penny of tax on the investment gains you earned along the way.

The right stocks for your Roth
Because of the right to take money out of your Roth IRA without paying tax, some of the concerns that exist with traditional IRAs don't apply to Roths. For instance, you don't have to worry about turning capital gains that would have qualified for a lower tax rate into higher-taxed income, as you do in a traditional IRA.

When it comes to your Roth, the optimal strategy is easy to figure out. Since Roths give you a unique opportunity to earn investment returns tax-free, the best way to make the most of your Roth is to buy investments that will produce the greatest returns. With that in mind, here are two strategies that work especially well in a Roth IRA.

Big risks, big rewards
One way to invest in a Roth is to seek out companies that are first to the punch in new industries. Often, those companies already have a history of strong share performance, which often tempts investors to conclude that their best days are behind them. Yet the combination of momentum, good management, and sustainable competitive advantages drives some stocks forward for explosive growth.

It's easy to find past examples of this. Baidu (Nasdaq: BIDU  ) duplicated the experience of the U.S. tech boom long after the bubble had burst by demonstrating its dominance in China. Intuitive Surgical (Nasdaq: ISRG  ) took a groundbreaking technology and built it into an effective monopoly with strong demographic trends supporting its industry. Even a concept as simple as Netflix's (Nasdaq: NFLX  ) mail-order video business has spawned huge profits.

Tomorrow's blockbusters are harder to figure out, but you can still see signs. Ancestry.com (Nasdaq: ACOM  ) , for example, has capitalized on a growing trend of interest in genealogy with its expertise and supporting programming.

You won't always hit the jackpot with picks like these, but when you do, the returns can be staggering. In a Roth, not paying any taxes makes those gains even more valuable.

Get special
Another angle for Roth investing is in special situations. These can produce quick profits that would ordinarily create a big tax headache in a taxable account, but they can be perfect for Roths. For instance, asset manager Affiliated Managers Group (NYSE: AMG  ) got beaten down during the bear market, but when it survived the market meltdown, shares soared. Those who got in cheap were able to score big gains in a short time period.

Another example comes from spinoffs. About 10 years ago, Sara Lee (NYSE: SLE  ) spun off its Coach (NYSE: COH  ) division. The move made plenty of sense -- what do handbags have to do with dessert, after all? But while Sara Lee has largely languished in obscurity, Coach has seen more than 20-fold returns since the spinoff.

Not every spinoff gives you gains like that. But a study from Lehman Brothers shows that the vast majority of spinoffs outperform the markets in their first two years as independent companies. That's a potential profit maker you won't want to miss, and with a Roth IRA, you don't have to worry about taking profits as soon as they're big enough to satisfy you.

Do it now
If you haven't set up an IRA yet, there's no time like the present. You have plenty of time before this year's April 18 deadline, but if you get started now, you'll have two extra months for your money to generate tax-free gains.

Have IRA questions? Leave a comment below. And be sure to tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

Want more great stock ideas? Take a look at this free special report, "5 Stocks The Motley Fool Owns -- and You Should, Too."

Fool contributor Dan Caplinger started his Roth over a decade ago and has never looked back. He doesn't own shares of the companies mentioned in this article. Ancestry.com, Baidu, and Intuitive Surgical are Motley Fool Rule Breakers recommendations. Coach and Netflix are Motley Fool Stock Advisor selections. The Fool owns shares of Coach. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy shows you all our best buys.


Read/Post Comments (23) | Recommend This Article (30)

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 February 16, 2011, at 5:16 PM, mikecart1 wrote:

    I'd rather use Roth IRA's for dividend stocks. It makes the dividends better knowing they won't be taxed. Plus a Roth IRA should be one of your conservative accounts when it comes to retirement. Save the risky picks to your active unlimited account. Roth IRA's are limited to $5000 a year which doesn't go far.

  • Report this Comment On February 16, 2011, at 6:33 PM, Fool wrote:

    I'm also a fan of your strategy, mikecart.

    Compounding Dividends + No Transaction Costs + No Taxes + Multiple Decades = Relaxed Retirement with lots of $$$ = Me buying my own Island

  • Report this Comment On February 16, 2011, at 6:41 PM, mountain8 wrote:

    My Roth is a mix. Besides solid dividend stocks or solid growth stocks I have as base, I have included my "gambles". i.e. those I think have the possibility of going sky-busters. Like SIRI, a conservative gamble that could return gobs, but still a gamble according to my defination of gamble. I put half my APPLE in my Roth when it became apparent to even me that it was gaining market stare and had a chance of running over microsoft. I think I converted it from my IRA to ROTH at about $50. All that nice increase with no taxes! Yum. Another is Melco, the gambling giant in Macau. I think I bought it at about $2, its around $7 and only growing more. No taxes on a 3 bagger that could trade in the $50 range in just a few years.

    One other note. As I am getting older, and it is apparent that I won't need all my investments unless I live to 100, rather than dumping a sure 35% tax bill on my son when he liquidates at my death, I have spent the last 5 or 6 years converting my IRA to Roth, $15-20,000 per year. All my current income is tax free so I'm actually paying only about $850 a year in taxes or at an 'under 5%' tax rate, vs the 35%(or +) he would have to pay if he cashed it while in my IRA. And he can keep the ROTH to pass on to his kids.

    Lot of reasons to convert or deposit into a ROTH. Depends on situations and outlook. These are mine.

  • Report this Comment On February 16, 2011, at 6:55 PM, Borbality wrote:

    I agree with Mikecart and TXinvestor82. I just opened and funded my Roth and went with the Vanguard ETF VIG.

    I'd rather search for home run stocks in a regular brokerage account, one my future isn't so dependent on.

  • Report this Comment On February 16, 2011, at 10:22 PM, mongoose1969 wrote:

    If I'm wanting to stock my Roth portfolio with ETFs is there a screen just for ETFs on fool.com? Trying to find it but not having much luck. Kinda new to this site.

  • Report this Comment On February 17, 2011, at 5:13 PM, ZuluFool1 wrote:

    I have the majority of my REIT stocks in my Roth account. Since these dividends are usually taxed at your income tax rate instead of captial gains rate, it is a great place to store these stocks.

  • Report this Comment On February 17, 2011, at 5:26 PM, TMFKris wrote:

    @mongoose1969: This is a link to the Fool's screener on CAPS. I'm not sure there's a way to screen just for ETFs, but you could click around and maybe find somethine helpful.

    http://caps.fool.com/Screener.aspx

    Kris -- TMF copyeditor

  • Report this Comment On February 17, 2011, at 5:28 PM, TMFKris wrote:

    MarketWatch seems to have an ETF screener

    http://www.marketwatch.com/tools/etfs/html-adv-screener.asp

    USA TODAY has something, too.

    http://etfs.usatoday.com/etf/screener.idms

    Hope these will help. I haven't used them.

    Kris - TMF copyeditor

  • Report this Comment On February 18, 2011, at 12:36 PM, rcalahan wrote:

    ZuluFool1 -

    If ROTH IRA's are good places for REITS, would the same be true for MLP's? thanks

  • Report this Comment On February 18, 2011, at 1:17 PM, Knightmare535 wrote:

    Here's an IRA question I've asked before but got no answer on:

    If my taxes are the same when I invest in an IRA as when I remove the money, the results are the same. For example, for $1000, compounded at 10%, at a 15% tax rate, the ending values after 5 years are:

    Traditional : $1000 x (1.1 interest)^(5 years) = 1610.51 after 5 years. Deduct 15% tax and you get 1368.93.

    Roth: Pay teh taxes up front and invest the remaining $850: $850 x (5 years) x (1.1)^5 = $1368.93.

    It looks to me like the only considerations are:

    1. I'm hoping my tax rate is lower when I withdraw the money, or

    2. If I put in the maximum, I can get more in if I pay the taxes upfront.

    The gain percent will be the same, though. Am I missing something? Also, can you contribute the max to both types of IRA's in the same year, or just a total of $5k between them?

  • Report this Comment On February 18, 2011, at 1:42 PM, MMinderbinder wrote:

    @Knightmare535: I don't think you are missing anything with your math - both IRA types come out equal if you account for taxes on both ends. I had money in a ROTH for over a year before I realized that- it seems like most articles about ROTH IRAs sort of gloss over it.

    I still contribute to the ROTH - I'm thinking it will provide some financial flexibility when I retire. I also used it when I was younger to sort of augment my emergency fund - since you can take the contributions out without penalty.

  • Report this Comment On February 20, 2011, at 6:31 PM, RideHD wrote:

    @Knightmare: My understanding is that the IRS will allow you $5K per year total per person for IRA contributions regardless of type. So, it would be up to you. For example, I use the Roth to offset my pre-tax 401K contributions I know will be taxed at withdrawal. The Roth contributions will be tax-free in retirement, at which time I suspect taxes will be higher than now.

  • Report this Comment On February 20, 2011, at 11:06 PM, obscurans wrote:

    @Knightmare535:

    IRS caps IRA and Roth contributions to $5k base per year total, plus catch-up and other additions. IRA contributions are pre-tax; Roth is post-tax so the equivalent dollar amount in a Roth is worth more.

    Note that IRA distributions are converted into ordinary income, taxable at the highest rates, regardless of how the money in there came to be. This means dividends, capital gains, all those categories *lose* their favorable treatment when you try and take it out - you're looking at a possible 20% hit.

    For estate planning, inherited IRAs/Roths pass through without much hassle, and aside from forced distributions/no contributions work pretty much the same. Now, since there is the option to spread out liquidation (hint: Roth) based on actuarial lifetime of the *inheritor*... 2+ generations untaxed appreciation.

  • Report this Comment On February 21, 2011, at 6:54 AM, LIfeAssuranceTX wrote:

    Something else you can consider, if your state allows it, we have clients that have put their IRA's or Roth's in life settlements. It's a passive alternative investment so that it won't require a lot of oversight if you don't like having to constantly check performance.

  • Report this Comment On February 21, 2011, at 9:59 PM, Leonidas07 wrote:

    I'm 22 and just opened up a Roth over the summer. Contributed the 5k max for this year and own JNJ, KO, INTC, LLY, and PG. Also have a regular brokerage account with T and MCD. Planning to sell those and buy back through my Roth after April 18th. Any advice as to other companies I should look at? For now I'm just holding and reinvesting the dividends for the companies I own. Thanks for any help!

  • Report this Comment On February 22, 2011, at 11:03 PM, rv3lynn wrote:

    The best part of a Roth account is the flexibility. Once the money is in, it is yours, and no Regulator can tell you how to handle it. If you go high risk when you are younger and then move into more conservative assets when you age, you could see above average returns, with income at the end.

    The problem with a traditional IRA is the IRS tells you when to take the money out and then shares the profits. This could be a shock, particularly for small businessmen that tend to try to minimize the tax bite during the earning years. You could end up paying a higher rate during retirement than you deducted when you made the contribution.

    A combination of both accounts is probably the best compromise

  • Report this Comment On February 23, 2011, at 1:22 PM, MFI1 wrote:

    @Leonidas07:

    You don't have to wait until April 18th to move those investments into your Roth. You can start contributing for 2011 as of January 1. Just make sure you aren't going to miss a dividend when timing the move.

    April 18th is only the cutoff for 2010 contributions, not the starting point for 2011.

  • Report this Comment On June 16, 2011, at 7:24 PM, c569089 wrote:

    I'm 18 years old and I heard that it is better to start investing in a roth IRA as young as possible. Why is that? Also, why are roth IRAs considered risky and just how risky are they?

  • Report this Comment On June 16, 2011, at 7:26 PM, c569089 wrote:

    Is it better to invest one large sum or to gradually add to the roth IRA?

  • Report this Comment On September 13, 2011, at 8:05 AM, alex233 wrote:

    I work and make over th limits for a IRA. Have 401k at work and max it out.

    Want to open a IRA this year and then convert it to a roth. My wife is a stay at home mom. Can I open a combined IRA and put $5000 for me and $5000 for my wife so we have $10K in a IRA – then want to convert it to a Roth IRA. Main goal is to get $10K into a Roth. Can I do this again in 2011 http://fidelityrothira.net

  • Report this Comment On October 14, 2011, at 1:05 AM, Billiken10 wrote:

    I've come up with a list of stocks that I plan on using in my Roth IRA because of the combination of small-cap / dividend growth, or value / dividend. This portfolio includes CT, PGH or ERF, CODI, GNK, and AIG. I'm only 24 years old, and this selection of stocks seems to me like a great combination of stocks that are undervalued, should provide great growth prospects given my time horizon, and it also acts as a good dividend portfolio. I just say all this to get perspective. Are there other stocks / industries that I should add to my list of possible stocks for my Roth? I feel confident with my choices, but I just like posting to see what other people's thoughts are.

  • Report this Comment On October 14, 2011, at 1:21 AM, OutperformOrDie wrote:

    To everyone above who has asked questions, good luck getting them answered by Dan.

    I will say, however, that after speaking with my financial adviser, much of the information provided by the commenters is incorrect.

    For example, it's best to allocate your high growth stocks in Roth IRAs and your dividend paying stocks and REITs in tax sheltered accounts.

    It's a good idea to speak to someone knowledgeable prior to sinking your money into any investment vehicle.

  • Report this Comment On August 09, 2012, at 3:12 PM, gravyluvr wrote:

    @OutperformOrDie I'd check another financial advisor just in case. Agree 100% that dividend stocks are not ideal and growth.non-div stocks are great for Roth but disagree 100% about REITs that do not tax at 15%.

    There is some good arguement that at this point with the Bush tax breaks still in effect you are likely looking at lower taxes today than tomorrow, but there is no gaurantee about tomorrow.

    REITs typically tax at your effective tax rate, so you are saving money by paying the taxes going into the ROTH since some of my REITS dividends are over 10%. I hold AGNC + AMT in my ROTH and will probably be adding some other REITS as well as my growth stocks in the future.

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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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