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Roth or not to Roth: It's now a 401(k) question

Refer to the Roth 401(k) and the likely response will either be a blank stare or a correction: “Oh, you mean a Roth IRA.” But the Roth 401k is real and may be the right plan for you.

Refer to the Roth 401(k) in conversation and the likely response from even the savviest of retirement savers will either be a blank stare or a correction: “Oh, you mean a Roth IRA.”

But really, there is such a thing as a Roth 401(k). There is even a Roth 403(b)for those who work in education or for non-profit organizations.

“Among our [large corporate] clients, nearly 12 percent currently offer a Roth option,” says Pamela Hess, director of retirement research at Hewitt Associates, the Lincolnshire, Ill.-based provider of human resource consulting services. “But we expect to see that number double during 2008. ”

That is not bad for a retirement-savings option that has only been in existence since 2006, and one few workers have even heard of.

"Many of our early adapters are financial-service company clients. Their employees are pretty savvy and many were motivated to both have and use a Roth option," says Hess. Among the most motivated were the new hires. "Twenty-five percent of the new-hires are using the Roth 401(k) where it is available," she adds. This is more than double the participation rate for all employees.

It is also possible these new employees just tend to be younger employees. They, after all, are the demographic group most likely to benefit from participating in a Roth plan. 

The reason?

“With Roth accounts it is a matter of paying now rather than paying later,” explains Barry Picker, CPA and a certified financial planner with Picker, Weinberg and Auerbach CPAs in New York City. That is the opposite of what happens with traditional 401(k) plans.

With traditional plans, taxes are paid later, at retirement — contributions are made with pre-tax dollars, which means that portion of your income is not taxable. Assuming one’s tax bracket in retirement is lower than it was when the contributions were made, it results in a sweet tax-saving deal for its participants.

Picker observes that most people like the idea of paying later. "They also like the [traditional 401(k)’s] instant gratification in the form of tax [liability]" he adds. "But the Roth actually can be a gift in the right situation." 

That situation involves someone who is in a lower tax bracket when they make their contribution than they will be when they start making withdrawals in retirement, explains Edward Dressel, president of Trust Builders, Inc. of Dallas, Ore., which provides retirement analysis software to advisers.  “Otherwise, there is no magic to the Roth,” he adds.

Roth 401(k)s are the inverse of traditional 401(k)s in that the taxman gets paid upfront. Contributions to these accounts are not deductible. But as long as withdrawals are made after the age of 59 ½, and provided the account was opened at least five years, no additional taxes are paid … ever, not even on future gains or reinvested income.

The Roth option, therefore, tends to offer the biggest bang for the after-tax buck to those employees who are just starting out. Their tax rates are likely to be much higher later in their careers.

The pay-now-reap-later aspect also attracts anyone, regardless of their age, who harbors a cynical suspicion that Congress will find a reason to raise individual tax rates just in time for all those baby boomer retirement dollars to begin their mandatory exit from all their tax-deferred retirement accounts.

For others, the Roth can represent a useful planning tool.

For some, "marginal tax brackets will probably fluctuate during retirement years,” says Dressel. During those higher marginal bracket retirement years, being able to draw some money out of a plan on a tax-free basis will be attractive. "During years with lower tax rates, [however] a participant may choose to withdraw just from their qualified [traditional 401(k)] accounts."  By having funds invested in both a traditional and a Roth 401(k) account, a future retiree gains what could be useful tax planning capabilities in retirement.

Unlike Roth IRAs, Roth 401(k) plans are not subject to the income ceilings that keep many wage earners, especially dual-income households, from contributing to them. But they are subject to the same mandatory withdrawals rules — beginning at age 70 ½ — that regular 401(k)s are subject to.

However, there is a way around those mandatory withdrawals.

Roth 401(k)s may be rolled over into Roth IRAs — without regard to any income restrictions — when employees change jobs or retire, in the same way traditional 401(k) accounts are rolled over into IRAs. But rolling over a Roth 401(k) into a Roth IRA gains access to one of the Roth IRA’s most compelling features: No minimum distribution requirements. This also creates a way to pass assets along tax-free to one’s children if withdrawals are never made or account’s balances remain at death.

Regardless of the flavor — Roth or traditional — contributions to 401(k)s are still limited to $15,500 for those under the age of 50 in 2007 and 2008, and to $20,500 for those who are 50 or older. If an employer offers a Roth, the employees may contribute all, none or a portion to it and the rest to a traditional 401(k) account — it is not an either/or decision.

In fact, where an employer matches employee 401(k) contributions, even if that employee elects to have all contributions made to their Roth 401(k), they will still end up with a traditional version as well. This is because employer contributions can only be made on a pretax basis, and therefore to traditional 401(k) accounts even if they are being matched to an employee’s Roth 401(k) contributions.

But for those just starting out in their careers, or anyone experiencing a year in a lower tax bracket than they expect to be in at retirement — or simply any taxpaying employee looking to hedge their bets against an uncertain tax bracket future — participating in a Roth plan offers an opportunity and the flexibility to manage the tax hit they will experience in retirement. 

To help understand exactly how the plan features differ, the IRS provides an easy reference chart on its Web site comparing the Roth 401(k), to the Roth IRA and a Traditional 401(k).