The ability to sock away after-tax money now and withdraw tax-free money in retirement has made Roth IRAs a favorite choice among investors, but Roth 401(k) plans might be an even better option than a Roth IRA; especially, for high income earning employees. Here's why.
A better option than a Roth IRA
There are two big differences between a Roth 401(k) plan and a Roth IRA that could make contributing to a Roth 401(k) plan the better option.
First, income limits restrict the use of Roth IRAs to those earning below a specific amount, but those income limits don't apply to Roth 401(k) plans. In 2015, the ability to contribute to a Roth IRA begins phasing out above $183,000 in income, so if you're a high income earner, Roth IRA plans aren't even an option.
Second, Roth 401(k) plans allow you to contribute more to them than Roth IRA plans do. That means that high income earners can not only contribute to a Roth 401(k) plan, but they can set aside more money in them too. In 2015, employees can contribute up to $18,000 in after-tax income to a Roth 401(k) plan ($24,000 if you're over age 50), but the contribution limit for a Roth IRA is just $5,500 ($6,500 if you're over 50).
A couple more things to keep in mind
Contributing to a Roth 401(k) plan, or a Roth IRA, makes considerably more sense if you assume that your income, and therefore your tax rate, will be higher during retirement than it is during your working years.
If your tax rate falls in retirement, or stays the same, then tax-deferred options, such as a traditional 401(k) or a traditional IRA, could make more sense because they may offer you greater tax savings given that they're taxed upon withdrawal, rather than when the contribution is made.
However, if a Roth 401(k) or Roth IRA account does make the most sense for you, there's another valuable benefit to them that isn't associated with traditional 401(k) plans or IRAs.
Since Roth 401(k) plans and Roth IRA accounts don't require you to take distributions from them, they can conceivably be left to compound interest for longer than traditional 401(k) plans and IRAs, which require minimum distributions to begin at age 70.5. This advantage may also allow you to pass along more tax-advantaged money to heirs.
Finally, if you're choosing between a Roth 401(k) plan and a Roth IRA, you ought to also think about the practical advantages of dollar-cost averaging into a Roth 401(k) plan every pay period, rather than waiting to do a lump sum investment into a Roth IRA prior to tax time.
Because Roth 401(k) contributions are made whenever you get paid, there's less of a chance that you'll over-ride your investment plan if the economy sours or if an unplanned expense comes up right before tax time. Additionally, dollar-cost averaging can reduce the risk of incorrectly timing a lump sum investment and that can lead to a lower average cost and greater long-term profit.
Overall, Roth 401(k) plans can be a great alternative to Roth IRA plans because they allow high income earners the potential for tax-free growth that otherwise wouldn't be available to them with a regular Roth IRA.