RSM Resources

Investors have poured tens of billions of dollars into Rothindividual retirement accounts (IRAs) since their introduction in 1997.The Roth IRA is popular with investors because it allows them to payincome taxes upfront and withdraw funds tax-free during retirement,versus socking away funds on a tax-deferred basis.

Now, for the first time, a similar retirement plan is available through employers.

TheRoth 401(k), as this new investment tool is known, combines the taxadvantages of the Roth IRA with the convenience of saving by payrolldeduction and the benefit of a matching contribution from someemployers. In addition, the income limits that restrict who can use aRoth IRA do not apply to the Roth 401(k).

Here’s how the Roth 401(k) works:

• Employees make contributions to a Roth 401(k) on an after-tax basis, compared with a pre-tax basis under a traditional 401(k).
• Employees can contribute up to $15,000 to a Roth 401(k) every year or up to $20,000 if over age 50.
• Investorscan make withdrawals from a Roth 401(k) beginning at age 59-1/2,provided the account has been open at least five years. Thosewithdrawals are not subject to federal income tax.

Forinvestors, tax-free withdrawals are the primary appeal of the Roth401(k) — a way to never pay taxes again on the invested funds and anyappreciation in value. But a Roth 401(k) may be more complex than atraditional 401(k).

For example, if an employee has $9,000annually to contribute toward retirement and is in the 25-percent taxbracket, that person could invest $9,000 in a tax-deferred 401(k) or$6,750 in a Roth 401(k). The $2,250 difference goes to the IRS.

Whilethe $9,000 would multiply faster in the decades ahead than the $6,750,the retiree who invests in a traditional 401(k) would still have to paytaxes when making withdrawals. If the employee falls into a lower taxbracket at retirement, the traditional 401(k) would have been thebetter investment. But if the employee is in a higher tax bracket atretirement, the Roth 401(k) would have been the wiser choice.

Ayoung employee with a promising career might be smart to invest in aRoth 401(k), because future earnings will likely place her in a highertax bracket at retirement. However, if an employee expects to be in alower tax bracket at retirement, a regular 401(k) might be the betterinvestment.

Predicting future tax brackets is no science, so itmay make sense to consult an online calculator. One such calculator isavailable at www.401khelpcenter.com.

Whileparticipants might welcome a new retirement-savings vehicle, plansponsors face a difficult choice when deciding whether to offer a Roth401(k).

Enacted as part of the Economic Growth and Tax ReliefReconciliation Act of 2001, the Roth 401(k) took effect on Jan. 1,2006. It will expire in 2010 unless Congress votes to extend it. Somecompanies wonder if it makes sense to add an employee benefit that maysoon disappear.

In addition, the Roth 401(k) isn’t easy tounderstand. Many employers find it difficult to explain traditional401(k) accounts and retirement planning to employees. The Roth 401(k),with its additional tax-planning issues, adds more complexity.According to a 2005 Transamerica retirement survey, seven out of 10Americans say they "do not know as much as they should" about investingfor retirement.

Another hurdle to offering the Roth 401(k) maybe its effect on nondiscrimination testing. Federal rules stipulatethat highly compensated employees cannot contribute a significantlylarger percent of their pay to a 401(k) plan than rank-and-fileemployees. If a significant number of workers sign up for the Roth401(k) but lower their contribution amounts because they lost thetraditional 401(k) tax deduction, the average percent of payrank-and-file employees contribute could decrease relative to highlycompensated employees. For example, a worker contributing $9,000 to a401(k) might invest only $6,750 in a Roth 401(k) after paying 25percent in taxes. On the other hand, highly compensated employees whocan better afford to absorb the upfront taxes might contribute at thesame or higher levels.

Stephen Utkus, principal at the VanguardCenter for Retirement Research, doubts many companies will facenondiscrimination testing issues due to the Roth 401(k). Since themajority of employees are in the 10 percent or 15 percent tax bracket,Utkus believes the contribution decrease won’t be steep.

"It may materialize as a problem for some companies," Utkus says. "But it won’t be a widespread problem."

Theuncertainty hasn’t stopped some companies from moving forward. About150 of Transamerica’s 16,000 small and midsized clients are nowoffering the Roth 401(k) to employees. So are a few big companies suchGeneral Motors, A.G. Edwards and Vanguard.

Despite the complexities of the Roth 401(k), Utkus is bullish on the new offering.

"Tosome plan sponsors and participants, this uncertainty may foster a’wait-and-see’ approach and a delay in adopting Roth savings," Utkuswrites in a Vanguard brief. "From our perspective, it suggests exactlythe opposite. Given the unpredictable nature of future taxes, manysponsors and participants are likely to be better off pursuing astrategy of tax diversification with the Roth 401(k) as soon aspossible."

In an interview, Utkus downplayed the complexity ofthe new Roth 401(k). When choosing between a Roth 401(k) and atraditional 401(k), it’s really a choice between paying taxes now andpaying taxes later. As a result, he predicts the rallying cry of theRoth 401(k) will be: "Never pay taxes again."

As an investmentstrategy, that argument is appealing for several reasons. In the past25 years, the number of tax brackets has declined, making it lesslikely that an investor will fall into a lower bracket at retirement.Therefore, it makes good economic sense to "lock in" a tax rate of 10or 15 percent, Utkus says.

Paying taxes on some investments nowis particularly important for individuals and couples who are goodsavers. If they don’t protect their retirement funds from taxes, theycould take a hit during retirement.

"Why not hedge your bets and pay some taxes today?" Utkus says.

Utkusis confident Congress will make the Roth 401(k) permanent. Hisreasoning: With soaring budget deficits, the government needs taxrevenue now.

If that happens, he predicts that 50 percent ofplan sponsors nationwide will adopt the Roth 401(k) in the next fiveyears. And younger employees — those who weren’t indoctrinated in theways of pretax retirement savings — will lead the way in choosing theRoth 401(k) as the place to invest for the future.