This Could Be The Perfect ETF For A Roth IRA

| About: iShares Select (DVY)

I am on the hunt for the best investments for a Roth IRA account. In a previous article, I listed the company Realty Income Corp. (NYSE:O) as one of the most attractive stocks for this type of account, due to the company's long-term track record of adding shareholder value. This is just one stock I like for the long-term and there are several other solid candidates which I will discuss in future articles.

However, I certainly wouldn't recommend owning just one or two stocks in a Roth IRA account and I absolutely recommend investors diversify their retirements accounts with a low-cost ETF.

Here, I will again list all the reasons for starting a Roth IRA account and give my two personal favorite choices for an ETF.

No Matter What You Choose to Invest in, Just Start... Now!

First off, I'd like to drive home the point that starting to invest early is the single most important factor to consider when both investing and planning for retirement. To put it simply, the earlier the better. As Albert Einstein once said, "compound interest is the most powerful force in the universe" - so, you should have the power working in your corner.

The key to retiring wealthy is to contribute regularly to your accounts, perhaps on a monthly basis, and try as hard as you can not to touch the money until you retire.

Here's what I mean:

Let's say you are 27 years old now. If you start today with $5,000 and add just $2,000 a year, or $166 a month, and you make on average 10 percent on your investments each year (which is very attainable as I will point out later on).

After a period of 30 years when you are age 57, you will have $449,133.86 in your Roth IRA account - which can be withdrawn tax-free at age 59 1/2.

However, we do also need to factor in the effects of inflation as well. For example, $449,000 today has about the same buying power as $191,000 did 30 years ago.

Still, even after taking inflation into account, the gains you can make from investing over the long-term are staggering due to the powers of compound interest through dividend re-investing and dollar-cost averaging.

The best times for you are actually the times when your stocks or ETFs are down in price, since short-term price movements don't matter as you are focused on the long-term and you can buy more shares for cheaper, giving you more dividends to re-invest. Normally you would have to pay taxes each year on these dividends, but like I said these dividend payments are not taxed in a Roth and can grow for years.

Check out the numbers for yourself with this compound interest calculator. If you add just a little bit more money each month and increase your returns slightly to 11 or 12 percent a year, the numbers get even more eye-opening.

Roth IRA or 401K?

Starting a Roth IRA account early is incredibly important due to the tax-free benefits the retirement account offers.

While a 401K continues to be a popular choice for workers, I strongly prefer a Roth IRA for a number of reasons. Mainly, I like the freedom of choice when investing in a Roth IRA: you can invest in stocks, ETFs, real estate, precious metals, bonds, etc.

When it comes to a 401K, however, you usually are only left with a few choices, which are often mutual funds carrying high expense ratios which can take a big bite out of your profits over time. This is my main problem with 401K accounts and I feel the entire mutual fund industry profits too much from it.

This freedom of choice in a Roth IRA allows you to choose between a number of blue-chip, dividend paying stocks such as Altria Group (NYSE:MO), McDonald's (NYSE:MCD) and as I mentioned in my previous article, Realty Income Corp. These stocks are all great long-term picks in my view because they have a very strong track record of paying and increasing dividends.

In general, I feel that these companies also have a solid history of returning value to shareholders via buybacks. These are the types of stocks you want in your Roth.

What are the Roth IRA Rules for 2014?

Another great feature of a Roth IRA is that you can take out your contributions when you want (but not your gains), without any penalty.

Unfortunately, you can't just pour all your money into a Roth as there are contribution limits. So, how much can you contribute to your Roth, exactly? For 2013 and 2014, the IRS website says the maximum you can contribute to all of your traditional and Roth IRAs is the smaller of: $5,500 ($6,500 if you're age 50 or older), or your taxable compensation for the year.

Note: The IRA contribution limit does not apply to: Rollover contributions and Qualified reservist repayments. (More details can be found at the IRS website here).

While I prefer the Roth IRA over the 401K, I am not against having a 401K completely, especially if your employer matches a decent amount of your contributions, which is basically free money. Just make sure you know what the annual expense ratio is for your investment of choice. If your employer only offers mutual funds with high expense ratios (I think anything over 1.3 percent a year is too high), then I would consider limiting your 401K contributions and instead focus on funding your Roth.

Stocks or an ETF?

In my opinion, there are several advantages and disadvantages to owning either stocks or an ETF in your Roth IRA.

First, I like the idea of selecting individual stocks because of the amazing upside potential that some of these companies hold. If you choose them right, your long-term holdings can absolutely smash any ETF or mutual fund out there.

For example, going back to Realty Income Corp., which has outperformed basically every major index since 1994 and boasts a 17.3 percent compounded average total return since 1994.

McDonald's is another great example, as the stock has returned 1,146 percent since the year 1990, which is far better than the Dow Jones and the S&P 500 since then, as you'll see in the chart below. However, this does not include dividends, so the total return is even greater.

If you go back even further with McDonald's, the returns are exceptional: an investment of $2,250 in 100 shares at 1965 has grown to 74,360 shares worth approximately $6.6 million as of market close on December 31, 2012, according to the company.

Shareholders have enjoyed yearly dividend increases, buybacks and share splits throughout the years.

Credit: Yahoo! FinanceClick to enlarge

While I still like the idea of buying a stock like McDonald's for a Roth IRA in today's world, you can't expect the same types of returns going forward (even though you can try).

I still believe that having low-cost, diversified ETFs that contain stocks which pay dividends is also a great idea because of the diversity you get. You also don't have to worry about the health of an individual company, as you would if you owned just a few stocks in your Roth IRA.

Perhaps the best idea is to have a combination of both.

What is the Best ETF for a Roth IRA?

I've searched far and wide for the best ETFs for a Roth IRA, and I am convinced that one of the best options out there for investors is the iShares Select Dividend ETF (NYSEARCA:DVY).

Here is some background info. on DVY and why I feel this ETF is superior to other ETFs:

- The DVY inception date was Nov. 3, 2003.

- Over the past year, the DVY has outperformed the Dow Jones, returning 24.49 percent. Since 2003, the ETF has basically tracked the performance of the Dow Jones.

- The DVY has an expense ratio of just .40 percent. This is compared to the average ETF expense ratio of .44 percent, according to the Wall Street Journal. This means a $1,000 investment will carry just $4 in expenses annually. Meanwhile, the average actively managed mutual fund can run you 1.2 - 1.8 percent in expenses, or $12-18 a year for a $1,000 investment.

- Next, the DVY contains stocks that have a positive dividend history, meaning that they have maintained and increased dividends each year.

- The DVY has 101 total holdings, giving investors plenty of diversification. Here is how the ETF is split up in each sector, which shows it is diversified:

Utilities

27.14%

Oil & Gas

4.81%

Industrials

18.80%

Technology

4.55%

Consumer G...

16.62%

Health Care

4.05%

Financials

10.89%

Telecommun...

2.05%

Basic Mate...

5.64%

Other/Unde...

0.31%

Consumer S...

5.14%

Click to enlarge

(Credit: iShares.com)

The DVY also contains some of my favorite long-term stock picks:

- 4.02 percent of the ETF is made up of Lorillard (NYSE:LO), a tobacco stock I am very bullish on in the medium to long term. Lorillard is a dividend paying stock with a 4.2 percent yield.

- 3.6 percent of the ETF contains shares of Lockheed Martin (NYSE:LMT), in the industrial goods sector. This is another great long-term pick yielding 3.8 percent.

- 2.04 percent of the ETF contains shares of Chevron (NYSE:CVX), a major oil company which yields 3.2 percent.

- Other holdings include Kimberly Clark (NYSE:KMB), which yields 3 percent, Philip Morris (NYSE:PM), which yields 4.3 percent, Norththrop Grumman (NYSE:NOC), which yields 2.2 percent, and, of course, McDonald's, yielding 3.3 percent. These are all solid long-term picks in my opinion.

Next Favorite: The Vanguard Dividend Appreciation Fund (NYSEARCA:VIG)

This ETF has a 5-year average annual return of 14.58 percent. The purpose of this ETF is to track the performance of the NASDAQ US Dividend Achievers Select Index (formerly known as the Dividend Achievers Select Index).

- The expense ratio for this ETF is just .10 percent! Just $1 a year per $1,000. Very, very low.

- The ETF contains over 140 holdings, so it is very diversified. Here are the percentages of holdings in each sector below.

Credit: Vanguard

- The ETF contains a number of stocks with a history of increasing dividends year after year.

Here are the top 5 holdings:

- PepsiCo Inc. (NYSE:PEP)

- Procter and Gamble (NYSE:PG)

- Walmart Stores (NYSE:WMT)

- Coca-Cola (NYSE:KO)

- Chevron

- The ETF has a yield of just over 2 percent.

- Since inception, this ETF has actually outperformed the DOW and the S&P 500 as you'll see below.

Credit: Yahoo! FinanceClick to enlarge

Conclusion: Start Now and Consider a Low-Cost, Diversified ETF

No matter what investments you choose - whether it be several individual stocks or an ETF (or both), it is imperative that you start investing for retirement as soon as humanly possible. The longer you wait, the more money you lose out on in the long-term.

I like both of these ETFs mentioned because I see them as long-term investments that should perform just as well, if not better than the actual market. They are also low-cost and I strongly prefer both of them over mutual funds, which often carry outrageous fees for underperformance.

I still think investors should consider a few individual stocks for their Roth IRA to get that upside potential. You should consider stocks that dominate their industry and have a solid history of paying and increasing dividends and buying back shares. Still, investing in a low-cost, diversified ETF like the two mentioned above is one of the safest long-term bets you can make.

Disclosure: I am long LO, DVY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.