Here's the Best Way to Invest a Roth IRA in Your 20s
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Q: I just rolled over a Roth 401(k) from my previous employer into a Roth IRA. How diversified should my Roth IRA investments be? How do I select the right balance being a 28-year-old? – KC, New York, NY
A: First, good for you for reinvesting your retirement savings. Pulling money out of your 401(k) can do serious damage to your retirement prospects—and that's a common mistake that many people make, especially young investors, when they leave their employers. According to Vanguard, 29% of 401(k) investors overall and 35% of 20-somethings cashed out their 401(k)s when switching jobs.
Cashing out triggers income taxes and a 10% penalty if you’re under 59 ½. And you lose years of growth when you drain a chunk of savings. Cash-outs can cut your retirement income by 27%, according to Aon Hewitt.
So you’re off to a good start by rolling that money into an IRA, says Brad Sullivan, a certified financial planner and senior vice president at Beverly Hills Wealth Management in California.
At your age, you have thirty or more years until retirement. With such a long-time horizon, you need to be focused on long-term growth, and the best way to achieve that goal is to invest heavily in stocks, says Sullivan. Over time, stocks outperform more conservative investments, as well as inflation. Since the 1920s, large cap stocks have posted an average annual return of about 10% vs. 5% to 6% for bonds, while inflation clocked in at 3%.
Granted, stocks can deliver sharp losses along the way, but you have plenty of time to wait for the market to recover. A good starting point for setting your stock allocation, says Sullivan, is an old rule of thumb: subtract your age from 110 and invest that percentage of your assets in stocks and the rest in bonds. For you, that would mean a 80%/20% mix of stocks and bonds.
But whether you should opt for that mix also depends on your tolerance for risk. If you get nervous during volatile times in the stock market, keeping a higher allocation in conservative investments such as bonds—perhaps 30%—may help you stay the course during bear markets. “You have to be comfortable with your asset allocation,” says Sullivan. “You don’t want to get so nervous that you pull your money out of the market when it is down.” For those who don’t sweat market downturns, 80% or 90% in stocks is fine, says Sullivan.
Diversification is also important. For the stock portion of your portfolio, Sullivan recommends about 70% in U.S. stocks and 30% in international stocks, with a mix of large, mid-sized and small cap equities. (For more portfolio help, try this asset allocation tool.)
All this might seem complicated, but it doesn’t have to be. You could put together a well-diversified portfolio with a few low-cost index options: A total stock market index fund for U.S. equities, a total international stock index fund and a total U.S. bond market fund. (Check out our Money 50 list of recommended funds and ETFs for candidates.)
Another option is to invest your IRA in a target-date fund. You simply choose a fund that’s labeled with the year you plan to retire, and it will automatically adjust the mix of stocks, bonds and cash to maximize your return and minimize your risk as you get older.
That’s a strategy that more young people are embracing as target-date funds become more available in 401(k) plans. Among people in their 20s, one-third have retirement savings invested in target-date funds, according to the Employee Benefit Research Institute.
Keeping your investments in a Roth is also smart. The money you put into a Roth is withdrawn tax-free. What's more, you're likely to have a higher tax rate at retirement, which makes Roth IRAs especially beneficial for younger retirement savers.
Still, you can't beat a 401(k) for pumping up retirement savings. You can put away up to $18,000 a year in a 401(k) vs. just $5,500 in an IRA—plus, most plans offer an employer match. So don't hesitate to enroll, if you have another opportunity, especially if the plan offers a good menu of low-cost investments.
If that's the case, look into the possibility of a doing a "reverse rollover": transferring your Roth IRA into your new employer's 401(k), says Sullivan. About 70% of 401(k)s allow reverse rollovers, according to the Plan Sponsor Council of America, and a growing number offer a Roth 401(k), which could accept your Roth IRA. It will be easier to stay on top of your asset allocation if you've got all your retirement savings in one place.
Read next: This Is the Biggest Mistake People Make With Their IRAs