Exchange-traded funds, or ETFs, are a popular way for people to invest while controlling costs, maximizing tax-efficiency and diversifying into different markets. Roth IRAs are also popular vehicles for long-term retirement savings due to their flexibility and their tax-free growth feature, plus the added advantage of being exempt from required minimum distributions that other retirement plans impose. Yes, you can invest in ETFs within your Roth IRA. There are advantages and disadvantages to the ETF structure, though, and you should understand them thoroughly before you invest.
ETFs invest in securities that are designed to represent and closely replicate a specific segment of the market. They are nearly always pegged to established indexes, which are simply groups of stocks selected to represent that market. ETF shares are traded over stock exchanges, just the same as any other listed stock, and investors can buy and sell them through stock brokers throughout the trading day.
Advantages of ETFs
Generally, you must pay a commission to a broker whenever you buy or sell shares of ETFs, so these may not be ideal for people who do a lot of trading. But their expenses tend to be lower than comparable open-end mutual funds that invest in the same market segment. And because the underlying index changes very rarely, there is little or no turnover in a typical ETF, which keeps capital gains tax bills low. Roth IRA investors don't have to worry about tax efficiency, however, since assets held in Roth IRAs are not subject to income or capital gains tax.
You must use a brokerage to purchase ETF shares, or purchase them through a fund company that runs ETFs and makes them available to its IRA account holders. If your favorite fund company doesn't list a brokerage option in its IRA menu, you may have to open up a separate account with a brokerage or ETF sponsor to purchase ETFs. You can do so using an IRA, Roth IRA or taxable account.
Many ETFs focus on extremely narrow segments of the investment world. When you purchase ETFs, keep careful track of your overall asset allocation. Otherwise, it is very easy for a narrow specialty ETF to undergo more volatility than you bargained for, and leave your overall portfolio severely unbalanced and vulnerable to a sudden market correction. Some ETFs employ leverage, which magnifies volatility and increases risk. A skilled financial adviser can help you manage your exposure to different kinds of assets and markets and help you avoid unwanted risk.
Leslie McClintock has been writing professionally since 2001. She has been published in "Wealth and Retirement Planner," "Senior Market Advisor," "The Annuity Selling Guide," and many other outlets. A licensed life and health insurance agent, McClintock holds a B.A. from the University of Southern California.