How Should I Invest Roth IRA Money?
A Roth IRA can be one of the best wealth-building tools as long as you invest within it properly. With its built-in tax benefits, Roth IRAs typically grow faster compared to other account types. This faster growth potential can allow you to reach your financial goals more quickly.
To give you a sense of this potential difference, investing properly within your Roth IRA can easily result in 200k+ more dollars in your portfolio by the time you retire.
The purpose of this article is to discuss the basics of your Roth IRA, describe how investing properly in your Roth IRA can lead to hundreds of thousands more dollars later in life, and caution you about five common mistakes we see people make when they invest their Roth dollars.
Our hope is that by the end of this article, you’ll have a better sense of how your Roth IRA should be invested so you don’t miss out on what will be essentially free money 10 to 20 years down the road.
Roth IRA Basics
The Roth IRA was introduced in 1997. IRA stands for Individual Retirement Account, and Roth is simply a reference to the individual who introduced this piece of tax legislation (shout out to William Roth).
The general idea of a Roth IRA is that individuals are limited in how much they can contribute, but what they are able to contribute avoids all future taxes on any growth within the account.
Here are a few key basics:
Money that’s already been taxed goes into the Roth IRA.
The money within the Roth IRA gets invested.
Those investments grow over time from dividends, interest, and appreciation.
Someday when you pull money out, it all remains tax-free.
This tax-free perk can be extremely powerful, and we’ll provide some examples to illustrate here soon.
Roth Investing Priority Number One: Growth
Because Roth IRAs will grow tax-free and distributions will be tax-free (assuming you follow all the proper rules), the top priority for your Roth IRA is growth.
Even as you approach retirement and are in retirement, it still usually makes sense to put assets with higher growth potential into your Roth IRA.
Saying that “the top priority for your Roth IRA is growth,” can mean a number of different things. What it doesn't mean is looking to buy the next Nvidia or implement some option trading strategy someone has sold you on.
As awesome as it might be to find the next Nvidia, what we mean by investing for growth simply means investing in a diversified portfolio that prioritizes stock investments over bonds or cash investments.
Since stocks have a higher expected return than bonds or cash over a 10+ year timeline, the expectation is that the more diversified stock investments you have, the more you’d expect to have a higher return over the long run.
Here’s a great chart from DFA showing the impact of adding more and more bonds to your investment portfolio:
Your specific allocation will vary based on your situation, but in any case, you’ll want to be very intentional about the percentage of bonds you choose to put in each type of investment account you have.
Rather than simply copy-pasting your ratio and exact investments across all your account types, you should consider changing the ratio of stocks vs bonds based on the account you’re investing in.
For example, rather than doing an 80% stock and 20% bond allocation in your 401k, taxable account, and Roth IRA, you could choose to do a 70/30 in your 401(k), 80/20 in your taxable account, and a 90/10 in your Roth IRA.
Example of Prioritizing Growth in Roth IRA Investments
To give you a sense of why this seemingly small change is so important, let's look at some projections comparing a taxable brokerage account to a Roth IRA.
Let’s say that you have $1M in investable assets.
$500k in a taxable brokerage account
$500k in Roth IRA
Here’s what it would look like if you were to copy-paste an 80% stock and 20% bond allocation across both accounts:
Comparing the two accounts in this example, the summed up After-Tax Values would be $2,995,405, and your Roth IRA would have ~$366k more after-tax dollars in it after 15 years than the taxable account.
This difference is to be expected because Roth IRAs will typically be more tax-efficient.
(1) The investments won’t generate taxable income, which would normally create a tax drag.
(2) All future growth avoids taxes when you eventually sell.
It is these two characteristics that make a Roth IRA the amazing investment vehicle it is.
So what happens when we optimize for growth?
Here’s what it looks like if we change the taxable account to a 60/40 allocation and a 100/0 allocation in the Roth:
Comparing taxable to Roth, your Roth would have $843k more after-tax value.
And when compared to our base example case of copy-pasting your investment allocation between accounts, prioritizing growth within your Roth IRA leads to over an additional $110,500 in after-tax investment value.
This strategy is often referred to as location optimization, and it is often overlooked because it requires a little bit of extra work. (Work that is well worth it if you ask us.)
Roth Investing Priority Number Two: Taxable Income is Okay
Because your Roth IRA makes everything tax-free, that means you can put investments inside of it that normally would create taxable income. (Also referred to as tax-inefficient investments.)
You can choose to include taxable bonds, real estate, utilities, or any investment that produces taxable income, and your Roth IRA makes it so there is no tax.
As you saw in our comparison between a Roth IRA and a taxable account, typically, what you invest in will create a little bit of tax drag on the portfolio. But that is not the case with your Roth IRA.
Roth Investing Priority Number Three: Expand Your Time Horizon
Roth IRAs do not have a required minimum distribution like 401(k)s or traditional IRAs do. Even once your spouse inherits your Roth IRA, they can easily avoid RMDs (at least as the tax code is written now).
And someday, if/when your kids inherit your Roth IRA, they’ll have RMDs, but all RMDs will be tax-free.
During your retirement, you may want to pull some money from your Roth IRA to help stay within certain tax brackets, but odds are good that your Roth IRA will be able to grow untouched for decades.
All this time should lead to significant growth, but because it can be hard to get money into Roth accounts due to smaller contribution limits, it can take time for your balances to be significant enough for you to embrace Roth’s potential.
Time is on your side with a Roth account. Usually, it’s best to leave it alone and just let it do its thing.
Common Mistakes When Investing Roth Money
Now that we’ve discussed what Roth IRAs are and have shared some top priorities for investing your Roth dollars, it’s time to caution you about the five common mistakes we see people make.
Roth Investment Mistake #1: Leaving Contributions in Cash
The first Roth investing mistake is leaving all or a portion of your contributions in cash.
This happens to people who are new to investing and even those who have years of experience.
We’ve seen individuals contribute the annual max to a Roth IRA or contribute via a Backdoor Roth and simply leave the money in cash. Cash will not grow at the same rate as other investments, and it will not outpace inflation.
A Roth IRA is the account, but it’s important to remember that you will still need to choose how to invest your money within that account.
Roth Investment Mistake #2: Not Optimizing for Growth
One of our top investing priorities is to optimize for growth; therefore, one of the biggest mistakes would be to not optimize for growth.
In our previous example, we shared one way to optimize for growth, but it’s worth emphasizing that most people don’t optimize their Roth money as they should. This is a common mistake. But now that you know, you can optimize better.
Roth Investing Mistake #3: Including Tax-Free Bonds
If you’re investing in something that provides tax-free income, it probably means that the percentage yield is less than what you’d be able to get from a taxable source.
Because all of the income produced within your Roth IRA is tax-free, the calculation doesn’t need to account for taxes. Instead, you should set your sights on holding income-producing assets/bonds you feel comfortable holding. (Even worse is when people hold tax-free bonds in a 401(k) or Traditional IRA, which turns tax-free income into fully taxable income someday!)
Tax-free bonds are often a great investment choice, just not in a Roth.
Roth Investing Mistake #4: Letting Advisors Charge Fees to Your Roth
We don’t see this mistake discussed enough, but your investment advisor (if you have one), probably shouldn’t be pulling management fees from your Roth IRA.
A dollar in a Roth account is worth more than a taxable account. By letting your advisor bill your Roth IRA, you’re significantly dampening your Roth account’s future return potential.
Most advisors know not to bill their clients’ Roth accounts, but we see it happen (1) when there isn’t another account, and/or (2) because it’s easier to just bill all accounts at an individual level.
For #1, if a Roth IRA is your only account and you’re working on building up your portfolio, you likely don’t need professional management.
For #2, what’s best isn’t always what’s easiest. If you request your advisor to “bill to another account,” my guess is that your advisor will oblige.
Roth Investing Mistake #5: Not Bothering to Contribute
If you’re a high earner, you’re probably unable to contribute to a Roth IRA directly. Instead, you will have to complete a Backdoor Roth Conversion or take advantage of a Mega Backdoor Roth (MBDR) through your 401(k) plan.
The contribution limits to a Roth IRA may seem so small that it can seem as though it’s not worth the hassle. When you throw in the annoyance of the administrative burden required to do a Backdoor Roth, people often just say “Meh” and don’t do it.
Please don’t underestimate what small, consistent contributions can become, especially with time and Roth’s tax-free power.
How You Should Be Investing Roth Dollars: Final Thoughts
The special characteristics of a Roth IRA makes it a powerful tool, but how you invest inside it determines just how powerful it becomes. Because every dollar of growth in a Roth is tax-free, every decision you make arguably carries more weight than it does in a taxable account or even a 401(k).
By prioritizing growth, choosing the right investment mix across all accounts, and keeping your sights on your long term goals, you’ll be able to turn your seemingly small Roth contributions into a sizable nest egg someday.
Helping clients figure out how to invest their Roth dollars is something we do regularly. If you’d like to learn more about how we advise our clients without charging asset management fees, please check out our services page and see why advice-only advisors are often the best fit.
