Why Stocks Are Best Held in a Roth IRA

Question: I’ve heard that stocks should be held in a Roth IRA and bonds should be held in a traditional IRA. But for tax-efficiency, shouldn’t cash-generating assets be held in the Roth and index funds in the other IRA?

Answer: Given the tax characteristics of the two types of IRAs, it’s generally better to hold investments with the greatest growth potential, typically stocks, in a Roth, while assets with more moderate returns, usually bonds, in a traditional IRA.

Here’s why: You invest in a Roth with after-tax dollars that can then grow and compound free of tax. Withdrawals will also be tax-free once you reach the age of 59 ½ and you’ve held the Roth for five years. And unlike a 401(k) or traditional IRA, you’re not required to start taking minimum withdrawals after age 70 ½. That means Roth investments can continue to grow for possibly decades.

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“Having your most aggressive or riskiest investments in your Roth is designed to maximize that tax free growth,” says Michael Peterson, a certified financial planner in Chambersburg, Pa. And if you don’t need the money in retirement, you can leave the Roth to your heirs, who will be able to take tax-free withdrawals, too.

With a traditional IRA, you’re investing with pretax dollars if you deduct your contributions on your federal tax return. Withdrawals are subject to ordinary income tax. By putting taxable bonds in a traditional IRA, you can get tax-deferred growth until you must start making withdrawals, says Peterson. And because bonds tend to have moderate returns than stocks, the tax bite when making withdrawals can also be much less than if you were selling greatly appreciated stocks from a traditional IRA, he says.

Additionally, if you hold volatile stocks in a traditional IRA, you might be forced to sell them during a mandatory distribution for a loss when the markets tumble, says Mike Giefer, a CFP from Minneapolis. This is less of a risk with bonds, which tend to be more stable, he says.

Don’t overlook the benefits of a taxable investment account. This is where you should hold municipal bonds whose interest is not federally taxed and can be exempt from state taxes, too, if the bonds are issued within your state. A taxable account can also be a good place for stocks that throw off few, if any, dividends.

Once you sell securities that have been held for more than a year in a taxable account, the profit will be taxed at a long-term capital gains tax rate–0% to 23.8 %, depending on your income. For many investors, that’s lower than their regular income tax rate. And if, say, some stocks throw off dividends, these often qualify to be taxed at long-term capital gains tax rates, too. (Non-qualified dividends, which include those from employee stock options and real estate investment trusts, are taxed at ordinary income tax rates.)