7 Best Funds to Hold in a Roth IRA - WTOP News (2024)

When it comes to maximizing long-term net returns, investors often focus on selecting the best funds or timing the market perfectly.

However, one of the crucial factors in enhancing returns is often overlooked: tax efficiency. The impact of taxes on investment returns can be significant, acting as a behind-the-scenes drag that reduces long-term net gains.

Investment returns can be eroded in several ways by taxes. Uncle Sam can take a portion of your returns through taxes on dividends, which are periodic payments made by some companies to their shareholders.

Then there are capital gains taxes, which apply to the profit from the sale of a security, and these can be categorized as either short term or long term depending on the holding period. Additionally, interest income from fixed-income investments is subject to taxation.

To mitigate this, U.S. retail investors have a potent tool at their disposal: the Roth IRA. This account was established in 1998 by Sen. William Roth of Delaware via the Taxpayer Relief Act and is now a crucial part of retirement planning alongside the 401(k) and Social Security.

“A Roth IRA is an account that you can contribute after-tax contributions to, with investment returns, income and dividends growing tax-deferred,” says Scott Krase, wealth manager at Connor & Gallagher OneSource.

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In exchange for contributing after-tax dollars, investors can shelter capital gains, dividends and income earned in a Roth IRA from taxation. Once an investor reaches age 59 ½ and a five-year holding period has been met, withdrawals can also be made both tax- and penalty-free to fund income needs.

“Roth IRAs are an attractive financial savings vehicle because investors can contribute to them regardless of age and take advantage of tax-free income in retirement, with no required minimum distribution, unlike a traditional IRA, which requires distributions at age 73,” says Tiana Patillo, financial advisor manager at Vanguard.

However, to qualify for a Roth IRA, investors will need to fall under a certain income threshold. “Modified annual gross income, or MAGI, limits on Roth IRA contributions for the 2023 tax year are $153,000 for single filers and $228,000 for married couples filing jointly,” Krase says. “For 2023, the contribution limit for most investors is $6,500, or $7,500 if you are 50 or older.”

Still, there are legal means to circumvent this limit. “If your income is too high for a Roth IRA, you could use a ‘backdoor strategy’ by placing your contribution in a traditional IRA, which has no income limits,” Patillo says. “Then, you’d move the money into a Roth IRA using a Roth conversion.” However, investors should note that this could result in tax consequences for the year the conversion was initiated.

Here are seven of the best mutual funds and exchange-traded funds, or ETFs, to hold in a Roth IRA, according to experts:

Vanguard 500 Index Fund Admiral Shares (VFIAX)

“Roth IRAs are especially beneficial for younger investors because there is greater saving potential due to that tax-free compounding,” Patillo says. When it comes to historical returns, few funds have been able to outpace the S&P 500 index, with around 92% of all U.S. large-cap funds underperforming it over the trailing 15 years, according to the latest S&P Indices Versus Active, or SPIVA, report results.

A low-cost pick for passively tracking the S&P 500 index is VFIAX. This mutual fund replicates the index by purchasing all of its constituent stocks. The result is both low fees, with a 0.04% expense ratio, and a low 2.1% portfolio turnover rate. However, VFIAX does require a $3,000 minimum investment. To avoid this, investors can also buy its ETF version, the Vanguard S&P 500 ETF (VOO).

Vanguard Wellesley Income Fund Investor Shares (VWINX)

“Generally, investors should allocate funds that are less tax-efficient in a Roth IRA,” says Lauren Wybar, senior wealth advisor at Vanguard. “For example, taxable bonds and real estate investment trusts make regular income payments, and actively managed stock funds are more likely to distribute taxable capital gains. The higher turnover and tax rates incurred by these investments make them ideal for a Roth IRA.”

A great example is VWINX, which is one of Vanguard’s oldest mutual funds dating back to 1970. This fund actively manages a portfolio of around one-third stocks and one-third bonds. The stocks are selected for above-average dividends that are forecasted to increase, while the bonds are mostly investment-grade corporate issues. VWINX charges a 0.23% expense ratio.

Invesco NASDAQ 100 ETF (QQQM)

“If you are younger and retirement is still years away, consider allocating a good portion toward mutual funds or ETFs that focus on growth,” says Jim Penna, senior manager of retirement services at VectorVest Inc. “Historically, these investments have potential for higher growth over time that you will generally pay no taxes on when held in a Roth IRA.” A great example is QQQM, which tracks the Nasdaq-100 index.

While QQQM is fairly tax-efficient with a low 0.7% 30-day SEC yield, investors who hold it in a taxable account will still have to pay capital gains tax if they sell for a profit. Given the Nasdaq-100’s strong historical returns, holding QQQM in a Roth IRA can help investors keep their profits intact. The ETF charges a reasonable 0.15% expense ratio, but be aware of its high technology sector concentration.

Invesco Zacks Multi-Asset Income ETF (CVY)

“To take advantage of the tax benefits, it is generally better to hold investments in your Roth IRA that would otherwise generate taxable income,” Penna says. “For example, stocks that pay dividends or generate capital gains, real estate investment trusts, or REITs, known for favorable dividend payouts, and high-yield bond funds also fit into this category.” In a Roth IRA, investors can keep the income earned.

A great example is CVY, a multi-asset ETF which holds not only dividend stocks, but also REITs, preferred shares, closed-end funds and master limited partnerships, or MLPs. The result is a fairly high 30-day SEC yield of 6.2%. However, the use of closed-end funds and MLPs gives this ETF a fairly high financial and energy sector concentration, so investors should be careful. CVY charges a 1.06% expense ratio.

iShares Core High Dividend ETF (HDV)

“High-yield funds that pay out dividends at a higher rate than a vanilla index fund are great candidates for a Roth IRA,” says Kaleb Paddock, founder and certified financial planner at Ten Talents Financial Planning. “In a taxable account, these funds can incur a significant tax drag on their yield.” A high-yield dividend ETF like HDV, which pays a 4.3% 30-day SEC yield, would be a good Roth IRA holding.

This ETF tracks the Morningstar Dividend Yield Focus Index, which currently holds 75 U.S. stocks screened for above-average dividends and solid fundamentals. Top holdings include familiar blue-chips like Exxon Mobil Corp. (XOM), Verizon Communications Inc. (VZ), Johnson & Johnson (JNJ) and Coca-Cola Co. (KO). As part of the iShares “Core” ETF lineup, HDV is also fairly cheap, with a 0.08% expense ratio.

iShares Cohen & Steers REIT ETF (ICF)

“In a Roth IRA, REIT funds are great holdings for taking advantage of the comparatively high tax-free distributions,” Paddock says. “In addition, you also benefit from price appreciation given the historically strong returns REIT investing and the real estate sector have provided.” For REITs, iShares has ICF, which tracks a concentrated portfolio of just 30 REITs represented by the Cohen & Steers Realty Majors Index.

ICF’s focus is on large-cap REITs, with Equinix Inc. (EQIX), American Tower Corp. (AMT), Prologis Inc. (PLD), Welltower Inc. (WELL) and Crown Castle Inc. (CCI) comprising its top five holdings at a 36.8% combined weight. The ETF also offers decent income potential, with a current 3.1% 30-day SEC yield. In terms of fees, investors can expect a 0.33% expense ratio.

Avantis U.S. Small Cap Value ETF (AVUV)

“Academic research shows that companies trading at low price multiples with good profitability are expected to outperform, and that this performance premium is greater within small caps,” says Ted Randall, senior portfolio manager at Avantis Investors. Hence, a small-cap value factor ETF like AVUV can be a way for advanced investors to try and beat the market long-term in a Roth IRA.

AVUV uses a rules-based active management approach to focus on small-cap U.S. stocks that are trading at low valuations and show robust profitability. “This combination implies these companies have a high discount rate embedded in their market price, and a high discount rate generally drives higher expected returns for investors,” Randall says. The ETF charges a 0.25% expense ratio.

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7 Best Funds to Hold in a Roth IRA originally appeared on usnews.com

Update 11/13/23: This story was previously published at an earlier date and has been updated with new information.