New Roth 401(k) lets people save more, but it may not last

PERSONAL FINANCE

October 02, 2005|By EILEEN AMBROSE

Not since the late 1990s have workers been offered a new type of retirement account, but that's about to change next year with the debut of the Roth 401(k).

As the name implies, this new savings vehicle combines features of the traditional 401(k) and the Roth individual retirement account, which was the last big retirement innovation.

Like the 401(k), workers potentially could set aside up to $15,000 in the account next year, plus another $5,000 if they are 50 or older. That's four times the amount older workers would be able to salt away in an IRA next year.

As with the Roth IRA, money goes into the account after income taxes have been paid. But you won't have to pay any taxes on contributions and earnings when you withdraw them at retirement.

"It's an opportunity to put much more money away and have it grow tax free," said Ed Slott, an IRA expert in Rockville Centre, N.Y.

Still, it's up to employers whether to adopt the Roth 401(k). At this point, many are taking a wait-and-see approach, preferring to learn from others' successes and mistakes and to see whether workers embrace the Roth 401(k), benefits experts said.

Three out of 10 large employers said they would likely offer a Roth 401(k) in January, according to a Hewitt Associates survey of more than 450 companies earlier this year.

About 10 percent of smaller employers are expected to add a Roth 401(k) in the next couple of years, according to Transamerica Retirement Services.

"They don't want to be the first out of the box," said David Wray, president of the ProfitSharing/401(k) Council of America in Chicago.

There are numerous reasons for employers' hesitancy.

The Roth 401(k) was created under the 2001 tax law that's set to expire in 2011. It's unclear what would happen to the accounts if Congress doesn't extend the tax breaks.

"The sunset provision is a bit of a turnoff," said Catherine Collinson, a senior vice president with Transamerica Center for Retirement Studies. Employers also are waiting for final Roth 401(k) rules from the Internal Revenue Service. And adding the plan could be an administrative headache for employers, experts said.

Then there's the hurdle of educating workers.

"It's complicated to explain and 401(k) plans are already confusing," said Robyn Credico, national director of defined contribution consulting with Watson Wyatt Worldwide. "You stand the risk of people not saving at all because it's really confusing."

The Roth 401(k) does have many parts.

If employers add a Roth 401(k), for instance, workers likely will have the option of putting their money in the new account, in the traditional 401(k) or splitting dollars between the two. (Roth 401(k)s would be an option, too, for schools and nonprofits that offer 403(b) plans, but not for state and local governments offering 457 plans.)

The Roth 401(k) doesn't have the same income limitations as the Roth IRA, where contributions are prohibited once adjusted gross income reaches $160,000 for married couples and $110,000 for singles. That's good news for those shut out of the Roth IRA.

Income test

However, like a 401(k), the new plan must be tested to assure that it doesn't heavily favor highly compensated workers. So, it's possible high-income workers won't be allowed to make the maximum contributions, benefit experts said.

Employers can match workers' contributions, but this money would be kept in a separate account and workers would owe regular income tax on it upon withdrawal.

Investors in a Roth 401(k) would be able to take the money out tax free and without penalty if they hold the account for five years and are at least 59 1/2 . Both the traditional and Roth 401(k)s require minimum distributions after age 70 1/2 . Roth IRAs don't.

If investors eventually roll their Roth 401(k) into a Roth IRA, they could avoid those mandatory distributions, experts said.

So, would you be better off with a new Roth 401(k) or sticking with the traditional 401(k)?

Much depends on your tax rates now and later, and the years to invest.

The best candidates

Most agree some of the best Roth 401(k) candidates are young workers with decades to build a nest egg and who would likely be in a higher tax bracket in the future.

"They are generally going to be good for people who are under age 50, or that are older than age 50 and expect their tax bracket to be higher, about the same or only slightly lower in retirement," said Stuart Ritter, a financial planner with T. Rowe Price Associates in Baltimore.

Those likely to fare better with a traditional 401(k), according to a Price analysis, tend to be those who would be tapping the account within five years and expect their tax rate by then to drop 7 percentage points or more.

But Slott argues tax rates are exceptionally low today. "Given the deficit, if anything, tax rates will go up," he said. With the Roth 401(k), workers are assured their tax rate will be zero on the account. "It takes the uncertainty out of future tax rates," Slott said.

Of course, one shock for Roth 401(k) investors will be the loss of the tax break upfront, Slott acknowledged. With a traditional 401(k), contributions are taken out of workers' paychecks before they pay any taxes on it. That lowers today's tax bill, although Uncle Sam eventually gets his due when withdrawals are taxed as regular income.

As word gets out about the Roth 401(k), benefits experts predict, workers will begin asking for it. And some employers may use it as a recruiting tool, which happened with the 401(k) after it was introduced more than 20 years ago.

eileen.ambrose@baltsun.com

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