Roth IRAs: Investing and Trading Do’s and Don’ts

More than 24 million households in the U.S. have Roth individual retirement accounts, which accounted for $810 billion in retirement assets as of 2019, according to the Investment Company Institute.  The retirement savings vehicles are funded with after-tax dollars, which means distributions are tax-free.

Roth IRA vs. Traditional IRA

Introduced in the 1990s, the Roth IRA is the younger sibling to traditional individual retirement accounts (IRAs), which are funded with pre-tax dollars and in which distributions are taxed as ordinary income. They are popular with the self-employed, and a portion of the taxes paid at distribution may be deductible depending on the taxpayer’s income.

Traditional IRAs are more popular, but Roth IRAs are the fastest growing among the different types of IRAs. The number of households owning Roth IRAs has increased on average 5.3% annually between 2000 and 2013 compared to a 1.3% growth rate for traditional IRAs.

While there are a few exceptions, you can hold just about any investment in this increasingly popular retirement account. Stocks, bonds, mutual funds, money market funds, exchange-traded funds (ETFs), and annuities are among the choices.

Most Common Investments

According to the Investment Company Institute (ICI), equity holdings figure most prominently in Roth IRA investments.

At year-end 2016, 65% of Roth IRA balances were in equities and equity funds. The next-highest percentage was non-target date balanced funds, at 10%. Target date funds, bonds and bond funds, and money market funds each made up less than 10%. At year end 2016, 78% of Roth IRA assets were invested in equity holdings (including equities, equity funds, and the equity portion of target date funds and non–target date balanced funds).

Prohibited Investments

There are a handful of investments that you are not allowed to hold in Roth IRAs. Collectibles, including art, rugs, metals, antiques, gems, stamps, coins, alcoholic beverages, such as fine wines, and certain other tangible personal property the Internal Revenue Service deems as a collectible are prohibited.

There are exceptions, however, for some coins made of precious metals. Life insurance contracts are also prohibited as investments.

Margin Accounts

Some transactions and positions are not allowed in Roth IRAs. The IRS does not allow you to invest in your Roth IRA with borrowed money. As a result, investing on margin is prohibited in Roth IRAs, unlike a non-retirement brokerage account, wherein margin accounts are allowed.

Margin accounts are brokerage accounts that allow investors to borrow money from their brokerage firm to buy securities. The broker charges the investor interest and the securities are used as collateral. Because the margin is leverage, the gains or losses of securities bought on margin are increased.

Certain trading strategies and contracts require margin accounts. This includes some options contracts, for example, that require borrowing on margin. You also can’t short stocks in Roth IRAs. Short selling occurs when an investor borrows on margin a stock betting that its price will decline. A profit is made when the investor buys back the stock at a lower price.

Roth and traditional IRAs are a way for investors to save and invest long-term toward retirement with tax benefits, not make a quick profit. Both buying and trading on margin are risky moves and not for the novice or everyday investor.

The Bottom Line

Roth IRAs are the fastest growing among the different types of IRAs, and some believe that paying the tax upfront provides an advantage overpaying tax on distributions, such as in regular IRAs. Roth IRAs allow for investing in a wide array of investment products, although there are a few exceptions. Check with your brokerage firm to see what it has on offer.