One of the primary benefits of Roth IRAs is the tax-free income they provide at retirement, but they have another big advantage as well: They provide retirement savers with a great deal of flexibility when it comes to choosing investments for the account. In most accounts your contributions can be put into a variety of investments, including stocks, bonds, options, mutual funds, exchange-traded funds (ETFs), index funds, money markets and certificates of deposit.
The scope of investment options makes Roth IRAs (and also Traditional ones) attractive vehicles for retirement savings. Still, all those choices can make it tricky to decide which investments will work best for you. To help you get started, here are three tips for choosing investments in your Roth IRA account.
Decide on Asset Allocation
Asset allocation refers to how your money is divvied up among different types of investments, such as stocks, bonds and cash. The main goal of allocating your assets is to minimize risk vis a vis an expected level of return.
Your ideal asset allocation depends largely on two things: your time horizon and risk tolerance. Time horizon refers to the number of months, years or even decades you plan on investing to achieve a certain financial goal. In the case of a Roth IRA, your time horizon can extend well after you reach age 70½—the age at which you must start taking required minimum distributions from a Traditional IRA. In fact, if you work beyond that age, you can continue to contribute to a Roth, an activity banned in Traditional IRAs.
Your risk tolerance is also a factor in deciding your asset mix. You should take enough risk to build wealth, but not so much that you’ll lose sleep every time the market takes a dive. In general, the more time you have to save, the higher will be the percentage of money you can allocate toward stocks and other higher-risk, higher-reward investments. A popular rule of thumb is to subtract your age from 100 (or 110 if you use newer guidelines) to determine the percentage of your investments that should be in stocks.
Guidelines aside, keep in mind that people are living longer—and are less prepared financially for retirement—which means you should still be building wealth well into your 60s and 70s. You have to take some risk to do that.
Choose Your Investments
Mutual funds, index funds and ETFs are popular investments for IRA accounts, because they allow you to buy a basket of investments simultaneously. This has a couple of benefits. One is that it provides a simple and effective way to diversify your investments. It also makes your investing job a lot easier: You could build a portfolio of stocks and bonds from scratch, but most people don’t have the time, confidence or experience to do it well. Funds are the “easy” button.
There are funds that track nearly every market and investment strategy out there. In general, it’s recommended that you allocate more of the equities portion of your IRA to stable stocks (e.g., large-cap funds) and less to smaller classes that tend to be riskier—such as small-cap funds and emerging markets. The same goes for bonds: Put most of your bond allocation into a total U.S. bond market fund and less into international bond funds. This strategy helps diversify your investments while also managing risk. Most online brokers and websites such as Morningstar and Yahoo have screeners that can help you sort funds by type, expense ratio, performance and other factors.
Get Help From the Pros
If you don’t have the time, interest or expertise to shop for and select funds or other investments for your IRA, you have several other options. One is to put all your IRA money into a single target-date fund. These are designed to work toward the year you plan to retire, automatically rebalancing along the way. Not surprisingly, they are named by year: If you plan to retire in 2040, for example, you would select a 2040 target-date fund, such as the Vanguard Target Retirement 2040 Fund (VFORX).
Another option is to use a robo-advisor—a digital platform that builds and manages a portfolio or ETFs using algorithm-driven models. In most cases you’ll pay a management fee of about 0.25 percent (some brokerages, including Schwab, provide this service for free). You’ll also fill out an initial questionnaire, so the robo-advisor can select appropriate investments based on your age, risk tolerance and other factors.
Finally, you can work with an investment professional who can manage your IRA for you. Many brokerages offer managed accounts. An annual advisory fee typically covers the ongoing management of your money, including investment selection, rebalancing and personal service and support.
No matter which route you choose, find out ahead of time which fees you’ll have to pay—including expense ratios, commission fees and account fees—and what they’ll cost you each year. Left unchecked, these fees can quickly erode your earnings, leaving your nest egg a lot lighter come retirement.