What's good for an IRA is good for a 401(k).

That was the thinking behind the new Roth 401(k) that takes effect on Jan. 1, 2006. On March 2, the Internal Revenue Service's treasury division issued a proposal to expand the 401(k) retirement plan by adding a Roth feature. Soon, 401(k) Roth contributions will be under the same rules as Roth IRAs, meaning the contributions will be expected to remain in the plan for five years to receive the tax-free advantage.

Whether an individual should choose a Roth 401(k) or stick to a conventional 401(k) depends on two things: an individual's income tax rate in retirement, and whether an individual can afford more than $15,000 in pre-tax 401(k) contributions.

Wooing the Big Three

According to a survey by the Lincolnshire, Ill.-based human resources consulting firm Hewitt Associates, 35% of companies are expected to have a Roth 401(k) option by the end of 2006. The survey further concludes that fund complexes like Fidelity Investments and Vanguard Group are likely to offer Roth 401(k) accounts through employer sponsorship.

"We've had interest from a number of our 401(k) clients who are considering adding this product in order to allow their employees access to the potential tax benefits of a Roth," said Sophie Launay, a spokeswoman for Fidelity in Boston.

"We will be offering it to clients that are eligible," said Chuck Freidoff, a spokesman at American Funds in Santa Ana, Calif.

Lori Lucas, director of participant research at Hewitt Associates, said people need to be made aware of its availability.

"Companies who offer the Roth 401(k) should plan a communication campaign that explains the feature and helps people understand whether it makes sense for them given their situation," Lucas said. "This can include online modeling tools, case studies, and frequently asked questions."

Pay Now, Instead of Later

Brian Perlman, vice president of the market research firm Matthew Greenwald & Associates in Washington, observed that under the new Roth 401(k) provision, by using after tax income and never being accountable for taxes on investment gains, the Roth feature is giving investors a chance to make a bigger contribution to their accounts.

Conventional 401(k)s are accounted for in what's called "before tax dollars." Therefore, if an individual were to make a $2,000 contribution now, for example, in pre-tax dollars, Uncle Sam could someday expect to be paid $300, or $560 or some other amount for taxes owed once monies are taken out of the account at retirement. With the Roth feature, an investor is paying the tax bill now and will never pay it again.

So a $2,000 contribution is a full $2,000 contribution. In raising the limits, this distinction becomes even greater.

"Whether an account is Roth or conventional, it makes no difference for tax savings on investment gains while you are working," he said. "Investment gain is not taxed in either account so tax brackets are irrelevant to the comparison." Furthermore, one could argue that with a conventional 401(k), those in higher tax brackets get a bigger tax deduction for the money they contribute, he said.

"Where the difference matters is during retirement, where highly paid workers will likely have much larger accounts and therefore be in a higher tax bracket when they withdraw. In this case a Roth feature can make a huge difference," Perlman noted.

Crossing Demographics

Younger workers may also find the Roth 401(k) attractive.

"Young people may be in a low tax bracket today, so it doesn't pay to do a conventional 401(k)," said Perlman. "The small tax break they get today may be eclipsed by a much larger tax bill they would have to pay upon withdrawing money after a long successful career."

"Catch-up" contributions were added to Roth 401(k)s for participants after age 49. Those individuals are allowed to contribute an additional $5,000 annually.

Lower-paid workers, meanwhile, will be able to make after tax contributions to their accounts, and thus, in a sense, be putting a larger investment amount to work.

"On the one hand, this advantage is worthless to most lower-paid workers, because very few contribute the max to their 401(k). So this ability to contribute more by paying the tax bill today' is of no value to them," said Perlman. "On the other hand, their tax bracket is lower, so forgoing the tax deduction today doesn't set them back that much. Those in really low brackets with lots of deductions might as well use the Roth and lock in the ability never to pay taxes in case their accounts grow - if the tax deduction doesn't amount to much today."

Distributions from 401(k) plans are allowed if an employee leaves or is terminated from employment. "The one negative aspect of the Roth is that its legislation needs to be extended in 2010 or it sunsets," Perlman warned. "That could put a rapid end to any benefits."

(c) 2005 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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