One of the most common Google searches you will find in regard to Roth IRAs (or any investment account, for that matter) will be how to find the best rates of return. What the people running a search with these terms are looking for is not how to do the math to calculate the return. Instead, they want to know the best places to find accounts with a high return rate.

Unfortunately for them, it isn’t that easy. The return of your Roth IRA isn’t set by the firm or bank where you open the account, like a CD or savings account. It is determined by the return of the investments inside the account.

Lesson 1: Roth IRAs, Traditional IRAs, and 401(k)s Are All Accounts

They don’t, by themselves, have any return. I like to think of my Roth IRA as a box. An investment box into which I put money. If I left that money sitting in the Roth IRA and I didn’t put it into an investment vehicle (for example, a CD, a mutual fund or individual stocks) it would earn $0 for me. It would just hold the money and do nothing. That would be bad—inflation would slowly eat away at the spending power of that money. By the time I got to retirement, even though the nominal amount would be the same, it would be worth a lot less than what it was when first placed in there.

Lesson 2: You Must Pick the Investments in Your Retirement Account

Sticking with the box example: You put money in the box. It sits there until you put it into an investment vehicle. Let’s say you max out your Roth IRA this year and deposit $5,500 into the account. You could split up that $5,500 investment by putting $1,500 into a 3-year CD, $2,000 into a bond index mutual fund, and $2,000 into a stock index mutual fund. Each of those investments would be envelopes in that box.

Lesson 3: Roth IRA Returns Are Determined by Investments

Let’s assume you invested that $5,000 through a financial institution and split up the money into envelopes at the beginning of the year rather than throughout the year with monthly deductions from your accounts. At the end of the year you decide to peek into the box to see how much money you have. You’re hoping it’s gone up or at least stayed at $5,500.

When you peek into the box, your three envelopes are gone. But don’t be distressed—the provider that holds your Roth IRA has simply taken the money in the envelopes and now holds those funds at its financial institution. Instead, you find a couple of pieces of paper in place of the original envelopes. This is the summary of your account and it shows how much money you deposited throughout the year, and what the overall return was.

That all-important number reads a +5.88% return for the year. Is this a best rate for your Roth IRA? That’s hard to tell, as it depends on what you were invested in and what happened in the relevant markets throughout the year. The point is,  whatever return you received—like it or not—reflects the assets you put in your Roth IRA box, and the not the Roth IRA itself.

The account itself does impact your investment returns in one sense: namely, in the size and sort of fees the financial institution charges for managing your Roth IRA. These will not be a big drain on your return, but over the years, they can add up.

The above article is by Kevin Mulligan.

Let’s look more closely at investment options for a Roth IRA, specifically certificates of deposit.

You’ve made a decision to put 25% of your portfolio in a CD. You look through the interest rate options and select a 5-year certificate of deposit with an interest rate of 2.60%. That’s all well and good. But you’ve taken on two pretty big risks to get that CD set up.

  1. You’ve locked up all of your funds for the entire five year period. If for whatever reason a situation came up where you needed to access those funds you would likely end up paying a penalty to withdraw from the CD before it matures.

  3. You’ve locked in a low interest rate. Sure 2.60% seems like a great rate today when interest rates are running about 1% for online saving accounts. But what happens when inflation starts to kick in or the Federal Reserve starts raising the prime?

Use a CD Ladder in Your Roth IRA

To combat these two risks you should use a CD ladder if you elect to use CDs in your Roth IRA. A CD ladder is a set of certificates of deposit with disparate degrees of maturity and interest rates. Instead of investing all of your funds into one giant CD, you spread them out over several CDs that come due at different dates.

A CD ladder avoids the risks of locking up your money and being locked into in a low rate. By spreading your investment across multiple interest rates and time periods, you’ll achieve greater liquidity and eventually improve your rate of return, too.

How to Set Up a CD Ladder

Let’s say you’ve got $30,000 you want to put into CDs. Instead of buying that single 5-year 2.60% CD, you decide to split the money up into a 12-month, 24-month, and 36 month CD. These are the rates you find:

  • 12 month: 1.35%
  • 24 month: 1.65%
  • 36 month: 1.90%

You’ll note those rates are lower than that offered by the single 5-year CD, but that’s okay. When you set up a CD ladder you’re anticipating lower rates in the short term. You are trading a slight bit of rate for increased liquidity and flexibility if rates change drastically. Instead of having to do without your funds for a full three or five years, you’ll get access to 33% of them every year—just in case you need to draw on them.

Hopefully, though, you’ll be able to roll the maturing 12-month CD funds into a new 3-year (36-month) CD. If interest rates have gone up in the past year, you’ll get the higher rate, rather than be stuck for five years with a lower fixed rate.

As time goes on you simply keep building rungs on the ladder. Every year, when a CD matures, you invest in a new 3-year CD. The time frame doesn’t have to be three years, by the way. You could pick five years if your financial institution also offered a 1-, 2-, 3-, and 4-year certificates of deposit. However high you want the rungs on your CD ladder to be is up to you.

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