What Type of Fund Should My Roth IRA Be?
The traditional IRA provides a tax break for workers as an up-front incentive to save for retirement. The Roth IRA provides a tax incentive as well, but it does so on the back end. Investors who follow the rules and invest in a Roth IRA can withdraw that money tax free when they retire, making the Roth a good choice for workers who feel that tax rates will be higher in the future than they are now.
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High Performing Funds
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The Roth IRA is the perfect vehicle for funds with stellar performance and high levels of capital gains, since those gains are sheltered from taxes within the plan. Roth IRA holders can use resources like Morningstar's guide to mutual funds and the quarterly wrap-up of mutual fund performance published by Barron's to find funds with a strong history of excellent performance. Investors should, of course, review all plan literature carefully, and look at things like the fund's holdings and the tenure of the money manager before making a decision or choosing a fund.
High Turnover Funds
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It is generally not a good idea to hold a high turnover fund in a taxable account, since the constant buying and selling of stocks generates capital gains, and capital gains taxes for the shareholder. With a Roth IRA, however, there are no tax consequences and no capital gains taxes. If you find a fund that has excellent performance but a high turnover ratio, your Roth IRA is the perfect venue for that fund. You can find information about the turnover ratio in the fund's prospectus and annual report, and in the Morningstar and Barron's guides.
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Index Funds
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While holding managed funds in a Roth IRA has a number of advantages, it can be hard to beat the performance of a simple low cost index fund. Index funds do not attempt to beat the market. Instead they simply buy and hold all the stocks in a given index. That guarantees the investor the market return, which over the long term can be better than that of many managed funds. In addition, index funds tend to have very low costs, and those lower costs can be significant over the life of the Roth IRA.
Exchange-Traded Funds
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Exchange-traded funds, also known as ETFs, provide many of the same benefits as index funds. In fact, two of the best known ETFs track the performance of the S&P 500 and NASDAQ 100 indexes. Those ETFs, which trade under ticker symbols SPY and QQQQ respectively, are priced throughout the trading day, unlike mutual funds, which are priced only once at the end of each trading day. That allows Roth IRA holders to buy and sell ETFs as they wish. And since the Roth IRA provides a tax shelter, there are no tax implications for making those frequent trades. Of course there are other costs, like brokerage commissions, to think about, so investors should use caution and avoid excessive trading whenever possible.
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