How to Use ETFs in an IRA

With exchange traded funds, investors can take a balanced approach in growing their assets through self-directed brokerage accounts as well as individual retirement accounts.

In an IRA account, ETF investors can grow their assets tax-deferred or tax-free as a way to lower overall costs, choosing between a traditional IRA or a Roth IRA, according to Morningstar ETF analyst Abby Woodham. With an IRA, investors can buy and sell ETFs without realizing capital gains or pay taxes on distributions. [Why Retirees Are Turning to ETFs for $1 Million Goal]

“An IRA account is a good location for income-generating assets, such as bond and dividend ETFs,” Woodham writes. “Young investors will have a relatively tiny allocation to bonds, but that amount will grow over time as they approach retirement. Dividend ETFs, which take up a 10% allocation in our ETF model portfolios, also make sense in an IRA, as tax-free compounding of reinvested dividends is a powerful force.”

For a traditional IRA, contributions are tax-deductible and grow year-to-year without triggering taxes. However, during retirement, any withdrawals are taxed at the investor’s ordinary income rate.

On the other hand, Roth IRA contributions are made after income tax is paid. Currently, investors can throw in $5,500 per year into a Roth IRA if they have an income less than $125,000,

In comparison, normal brokerage account would trigger taxable events on capital gains whenever investors rebalance through the year. Additionally, distributions made, such as dividends or coupons from fixed-income assets, are also taxed.

Additionally, the IRS allows IRA investors to withdraw assets to pay expensive life events, like higher education from an accredit institution, certain home-related costs or unreimbursed medical costs that exceed 7.5% of your gross income, without an early withdrawal penalty.

Investors can create IRA accounts with any number of online broker accounts. Moreover, users can also trade ETFs commission-free if the brokerages offer the option. [Six Popular Commission-Free ETF Trading Platforms]

For more information on investing toward retirement, visit our retirement category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.