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Roth IRAs and Your Portfolio

Roth IRA accounts are excellent compliments to traditional retirement accounts. The pre-tax savings vehicles (401k, 403b, Traditional IRA, etc.) provide the best way to save for retirement. Most employers offer an annual match in a 401k program that offer returns significantly better than the stock market in its best years. But once that match has been reached, many people choose to open a Roth IRA for tax reasons. If you expect to be earning more money per year when you are ready to start withdrawing funds than you are now, it is advantageous to open a Roth. The money in your Roth IRA account has already been taxed (presumably at a lower rate than when you are ready to retire) and will not be taxed again when you start withdrawing. The money you start pulling out of your 401k, however, will be taxed as normal income. Once people have funded their 401k up to the company match and contributed to their Roth IRA to the legal maximum, the 401k again becomes the best place to invest retirement savings. After the 401k has reached the maximum annual investment amount, taxable accounts are the only real option remaining.

Opening a Roth IRA Account

Just about every financial institution around will be more than happy to open a Roth IRA account for you. Where you actually should open your account depends on your goals, investment intentions, and initial contribution amount. Like a 401k or traditional IRA, almost any asset class can be placed in your Roth. If you want to buy nothing but individual stocks, bonds, mutual funds, index funds, penny stocks, or whatever else, you can put those investments in your Roth.

All of the popular online brokerages such as E*Trade, Scottrade, Sharebuilder, Tradeking, and others allow you to open an account as a Roth IRA. Mutual Fund companies such as Vanguard and Fidelity also make opening an account fairly simple. If you are interested in Money Markets or CDs, most local banks have Roth IRA options for you. Some institutions require minimum deposits to open an account or other limitations that may influence your decision. For example, Vanguard may offer some of the best index funds around, but most of them require $3000 to open. Online brokerages charge per trade, regardless of size. What type of assets you want to hold in your account is the most important factor in deciding where you should open your Roth IRA.

It is possible to have more than one Roth IRA account with different financial institutions. The annual limit still applies per individual, not per account, so it is up to you to keep track of how much you contribute to each account. Your annual tax forms will show how much you contributed to each and report that data to the IRS, so you will be penalized if you go over the annual limit.

Tax Inefficient Assets

While you can place any type of asset in your Roth IRA, the tax advantages of the account make it especially attractive for certain kinds of assets. While stock trades in a taxable account are hit with capital gains taxes, the Roth IRA account shelters you from the taxes and allows your investments to grow.

Hopefully, you already are taking advantage of pre-tax accounts such as a 401k, 403b, or Traditional IRA before investing in your Roth. Pre-tax accounts are ideal for tax-inefficient assets. High-Yield bonds, taxable bonds, Treasury Inflation-Protected Securities (TIPS), and Real Estate Investment Trusts (REIT) are tax inefficient funds that would take advantage of your standard retirement account. Hopefully you still have some money left for your Roth IRA, where Balanced Funds, individual stocks, and most Small or Large Cap mutual funds can grow most effectively. If you have contributed the maximum allowed amounts for your standard retirement account and your Roth, you can continue to save in taxable accounts. Here, index funds, tax-managed mutual funds, Government Savings Bonds, and tax-exempt municipal bonds allow you to maximize your savings while protecting you from taxes.

The most important aspect of your Roth IRA is simply starting one and saving. Most people will want to use their 401k plan up to their employer's match and then open a Roth IRA. Deciding what assets to place in which account becomes important when you have multiple accounts and want to maximize your tax efficiency. If the complexity of choosing the right funds to invest in is keeping you from opening an account, there are options that make it easy without sacrificing performance.

Or Keep it Simple

A growing trend with large financial institutions is Target Retirement funds. These mutual funds are specially designed to maintain a popular asset allocation for your target retirement year. As you grow older, the funds becomes more conservative automatically. These funds make it easy to contribute to a well diversified fund without having to research funds, performance, and costs.

The disadvantage of these funds is that the asset allocation provided may not be the best for you. If your tolerance for risk is not different than most people in your age range, the target funds may have the wrong mixture of assets for you. When combined with other retirement accounts, you may also accidentally overexposure yourself to a specific fund class if you do not analyze what is held in the target retirement fund you decide to purchase.

Overall, the target retirement funds are excellent choices for people who want to save, but don't want to worry about their investments and don't have time to research a customized portfolio.

Next: Read some Frequently Asked Roth IRA Questions
Page last modified 2/26/2012