As of 2018, U.S. savers had stashed nearly $7.4 billion in their IRAs. No doubt a good many of those dollars were deposited solely for the annual tax deduction. There's no shame in that, but if you're locking money up in an IRA, you might as well make sure those contributions are invested appropriately.
Your biggest obstacle to that end is deciding what is appropriate in your IRA. You have your choice of the full range of stocks, bonds, and funds available to you in that account. All that choice can be overwhelming, especially when you're not really sure what your investing approach is or should be. To help you clarify that right now, here are three IRA investment strategies that can guide you going forward.
1. Manage asset allocation
Asset allocation is the composition of different asset classes in your portfolio. The main asset classes are stocks or equities, bonds or fixed-income, and cash. The key point about asset classes is that each has its own characteristics and behaviors. Stocks, for example, generally grow in value over time, but that growth can be volatile. Bonds don't deliver high returns but do produce reliable flows of income. And then your cash balance doesn't change based on market conditions, but cash does lose purchasing power over time due to inflation.
The relative amounts of each asset class you hold in your portfolio should match up with your risk tolerance and investment timeline. For example, if you are 25 years old and risk-tolerant, you have the time and the emotional resilience to handle some ups and downs in your portfolio. You could invest 90% of your savings in stocks for maximum growth potential. Your target allocation would be different, however, if you are 55 and risk-averse. At that point, you'd rather avoid big losses even if it means giving up some returns. In that case, you need a more conservative allocation, something like 60% stocks, 35% bonds, and 5% cash.
You'll want to apply your target allocation across your financial accounts, even if you depart from it within your IRA. In other words, you might have 100% bonds in your IRA if you have a larger percentage of equities and cash elsewhere to bring your allocation across the board in line with your target.
2. Work your tax deferrals
Investment earnings, dividends, and interest in your IRA do not incur taxes from year to year. For that reason, it's wise to use your IRA to invest in assets that are not tax efficient. That can be anything producing regular income or capital gains. Examples are taxable bonds and bond funds, income stocks, real estate investment trusts (REITs), and mutual funds that make capital gains distributions. If you are actively trading, individual stocks fall into this category, too.
Exchange-traded index funds, tax-free bonds and bond funds, and your buy-and-hold stocks that don't pay dividends don't need to be in your IRA. That's not to say you can't hold them there. You can, but there's less of a tax advantage because these assets produce lower amounts of taxable income anyway.
3. Lean on funds
Although you can invest in individual stocks in your IRA, stock picking isn't for everyone. You need to have an established process for selecting your investments, tracking their performance over time, and knowing when it's time to part ways.
If you don't have that process in place or you don't want to put in the time, a mutual fund strategy is a better option. A big advantage is that mutual funds are already diversified. That lowers your risk, and it also lowers your entry costs. A single share of Vanguard High Dividend Yield ETF (NYSEMKT:VYM), for example, will cost you about $85. That fund holds 428 separate positions. You'd have to spend thousands to build a minimally diversified portfolio of 20-plus positions on your own.
Those perks are magnified when you combine mutual funds to meet your allocation needs. For example, a bond fund, international bond fund, domestic total market stock fund, and international total market stock fund together give you broad-based exposure across asset classes and geographies for a low initial outlay. Again, you might want to hold some of these in your IRA and some elsewhere if your IRA funds are limited and you want to maximize your tax savings.
Your IRA plays a key role
Annual IRA contribution limits are fairly low -- $6,000 in 2020 or $7,000 if you are 50 or older. If you are not saving more than those amounts for retirement today, you hopefully will be soon. That makes your IRA a subset of your larger retirement savings plan. The IRA shines when you use it for investments that would otherwise raise your tax bill substantially. If you do take that approach, remember to keep an eye on your overall asset allocation, too.