Investors can purchase a wide variety of assets within a Roth individual retirement account (IRA), including exchange-traded funds (ETFs). You can buy ETFs for your Roth IRA easily when your retirement account is held by an online broker or a traditional broker-dealer. Including ETFs in your Roth IRA can be a simple, inexpensive, and effective way to invest for your retirement.

The potentially attractive returns offered by carefully selected ETFs are magnified by the tax-free growth afforded by a Roth IRA.

Benefits of ETFs in a Roth IRA

ETFs within a Roth IRA can be a great way to invest for the long-term to reach your financial goals in retirement.

• ETFs can help you build a solid retirement portfolio because of the diversification offered by a single, convenient, and easy purchase.
• A majority of ETFs are passively managed, which means lower expense ratios for investors. These ETFs normally track broad indexes as well as sectors. For example, some ETFs track market indexes such as the S&P 500 Index and the Nasdaq Composite Index. Other ETFs track sectors such as technology, healthcare, real estate, financials, environmental, social, and corporate governance (ESG), and more.
• ETFs trade intraday on an exchange during market hours, just like stocks. This flexibility offers investors the advantage of being able to buy an ETF when they see opportunities and to sell when they want to capture profits.
• You pay no taxes on the gains returned by any ETF, whether those are accrued capital gains, interest income, or dividend payments.
• Leveraged ETFs may offer investors the potential for higher returns. A leveraged ETF uses derivatives and debt to increase the returns of the underlying index that it tracks. Keep in mind that while returns can be boosted on the upside, leveraged ETFs can also amplify losses, making them risky investments. They also carry higher costs than traditional ETFs.

How To Choose ETFs for a Roth IRA

Choosing the best ETFs for your retirement investing can be challenging because so many funds are available. To help focus your search, consider the following steps:

1. Define your investment objectives: For example, do you seek growth through capital appreciation of assets, current income rather than growth, or a combination of the two? Remember growth-oriented funds are appropriate for a Roth IRA because of its tax-free growth advantage.

2. Review your tolerance for risk: If you're an older investor in or approaching retirement (or a conservative investor of any age), you may want to consider ETFs that aim for income or growth and income. On the other hand, younger investors can tolerate more aggressive growth ETFs that aim for capital appreciation because they have time to withstand market downturns.

3. Take note of existing investments: Revisit your investments so that you don't overweight your portfolio with the same or similar investments offered by particular ETFs that may catch your eye.

4. Understand expense ratios: The expense ratio of a fund tells you your annual cost to own an ETF. The lower the expense ratio, the less of a drag on your return, the better for you. According to the Investment Company Institute, the asset-weighted average expense ratio for equity index ETFs in 2022 (the latest data available) was 0.16%.

5. Search for funds that meet your criteria: Check with the company where you have your Roth IRA for an ETF screener to research ETFs that meet your criteria, as determined by the preceding steps.

Limitations of Holding ETFs in a Roth IRA

While ETFs offer Roth IRA investors some major benefits, they also have some limitations. For example, ETFs may involve trading commissions, particularly if using brokers that charge fees for ETF transactions. Such expenses may erode your Roth IRA earnings. However, many brokers have zero commissions on listed stocks and ETFs, making these assets free to buy and sell at most online brokers.

Investors should also be mindful of market price deviations from net asset value (NAV), known as tracking error. Tracking error means your order may be filled at a price that's different from what a security is trading for.

On top of this, some ETFs that trade less frequently than others, such as niche ETFs, pose liquidity concerns. Low liquidity can impact the bid-ask spreads and potentially trade values, and result in higher costs for investors.

The Bottom Line

ETFs are just one of the many types of investments allowed in a Roth IRA. They offer investment simplicity, diversification, low costs, and the flexibility to trade like a stock.

To include ETFs in a Roth IRA, you’ll need to have an account with a financial institution that offers them.