You can invest in a wide variety of assets in a Roth individual retirement account (IRA), including exchange-traded funds (ETFs). When your Roth IRA is held by an online broker or a traditionalbroker-dealer, it can facilitate the purchase of ETFs.
Including ETFs in your Roth IRA can be an inexpensive and effective way of investing in your retirement. The returns that you’ll see from adding carefully selected ETFs are magnified by the tax-free growth afforded by a Roth IRA.
Key Takeaways
- Exchange-traded funds (ETFs) are among a wide variety of investments that you can choose for a Roth individual retirement account (IRA).
- They can help build a diversified retirement portfolio.
- Typically, ETFs have lower fees than mutual funds, making them a cost-effective investment.
- ETFs trade on an exchange like stocks, which provides flexibility.
- Growth and income ETFs can be a good fit to include in a Roth IRA because investment gains and withdrawals are tax free.
Benefits of ETFs in a Roth IRA
ETFs are a great way to build a solid retirement portfolio because they provide diversification and typically have lower fees than traditional mutual funds. A majority of ETFs are passively managed and track indexes and sectors, which result in lower expense ratios.
Like mutual funds, ETFs offer both broad diversification and access to very specificsectorsin the market. For example, there are ETFs that track specific indices such as the S&P 500, technology sector ETFs, and socially responsible ETFs. Another benefit is that ETFs trade on an exchange like stocks, unlike mutual funds, which can only be purchased at the end of each trading day.
Creating leverage within a Roth IRA can be next to impossible due to investment restraints on retirement accounts. Including a leveraged ETF in your Roth IRA is one way to solve this problem. A leveraged ETF uses derivatives and debt to boost the returns of the underlying index that it tracks. Keep in mind that while returns can be boosted on the upside, leveraged ETFs can also amplify losses, making them riskier investments.
Leveraged ETFs are best suited for sophisticated investors with a high risk tolerance.
Choosing ETFs for a Roth IRA
ETFs simplify the task of investing. They trade like a stock during market hours and provide investors access to a basket of many stocks in one product. At the same time, choosing the best ETFs for retirement can be challenging because so many are available.
Consider the tax advantages of Roth IRAs. Contributions are made with after-tax dollars, which means that investments grow tax free and you also don’t pay any tax on withdrawals at retirement. More aggressive and growth-oriented funds are appropriate for a Roth IRA because of the benefits of tax-free growth.
If you are nearing retirement or are already retired, you may want to choose ETFs with high income distributions. These could be distributed to you as tax-free retirement income.
Launched in 1993, the first ETF was the SPDR S&P 500 ETF (SPY). It tracks theS&P 500 Index.
Limitations of Holding ETFs in IRA
You should be aware of several downsides to holding ETFs in your IRA. While ETFs offer benefits such as diversification and ease of trading, there are some limitations.
ETFs may include the possibility of trading commissions, particularly if using brokers that charge fees for ETF transactions. This means transaction expenses may erode your IRA earnings. Investors should also be mindful of market price deviations from Net Asset Value (NAV), known as tracking error. Tracking error means you may receive a different price than what a security is truly trading for.
On top of this, some ETFs may come with liquidity concerns. Some less-traded or niche ETFs may not have a lot of shares available to buy or sell, and this may impact the bid-ask spreads and potentially trade values.
Last, there are some tax considerations when invested in ETFs. Capital gains distributions within the ETF may trigger some tax considerations, though you're likely sheltered if these are held in a retirement account. One thing to consider is how traditional IRA gains are simply tax deferred, so you'll eventually pay taxes on these. In addition, IRAs may come with required minimum distributions which may trigger taxes in the future.
What are Common Roth Individual Retirement Account (IRA) Investments?
Most financial assets can be held in a Roth individual retirement account (IRA)—exceptions include life insurance and collectibles. Common Roth IRA investments include stocks, mutual funds, and exchange-traded funds (ETFs).
What Is an Expense Ratio?
An expense ratio is the combination of fees that covers a fund’s annualoperating expenses. In general,passively managedfunds, such as a majority of ETFs, typically have lower expense ratios than actively managed funds.
How Much Can I Contribute to a Roth IRA?
The annualcontribution limit for a Roth (and traditional) IRAis $6,500 in 2023 and $7,000 in 2024. If you are age 50 or older, you can contribute an additional $1,000.
The Bottom Line
ETFs are among the many types of investments allowed in a Roth IRA. They offer a combination of diversification, low costs, and the flexibility to trade like a stock. To include ETFs in a Roth IRA, you’ll need to have an account with a financial institution that offers them.
