New Roth 401(k) Looks Dandy, But Few Can Play

Lynn O'Shaughnessy
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Posted: Jan 10, 2006 11:34 AM

What would happen if you threw a party and nobody came? The federal government could discover how that feels in January. That's the date for the official coming-out party of the Roth 401(k), which represents an intriguing new way to save for retirement.

I can tell you one big reason why millions of Americans won't be participating in the Roth 401(k)'s rollout: They haven't received invitations.

A study conducted by Hewitt Associates, a human resources consulting firm, suggested that just 7 percent of employers definitely plan to offer the Roth 401(k) to their workers in 2006. Many other workplaces remained noncommittal.

Under the circumstances, it's hard for workers to get excited about the new Roth when they can only watch from a distance with a set of binoculars.

A study by the Vanguard Center for Retirement Research, however, makes a compelling case for why employers should get off their rears. It suggests that many types of workers would greatly benefit from investing in a Roth 401(k) - if they only got the chance.

I devoted a column to Roth 401(k)s earlier this year, but the new research convinced me to write about the subject again in hopes that readers will nudge their employers to do the right thing. If you can't remember why a Roth 401(k) can be an invaluable retirement tool, let me recap.

Unlike a regular 401(k), the money diverted into a workplace Roth will be taxed upfront.

But after you bite that bullet, the cash grows tax-free in the account. When you pull money out during retirement, no taxes are owed. In contrast, the cash deposited into a traditional 401(k) isn't initially slammed with taxes. A participant won't pay the tab until he or she starts drawing down the account. At that point, an investor will owe income tax on the withdrawals.

Next year, you'll be able to sink up to $15,000 into either a Roth 401(k) or the traditional kind if your workplace offers both. You could also split the money between the two types of 401(k)s in any way you want as long as you don't exceed the contribution ceiling.

Workers who are 50 or older can sink an additional $5,000 into either of the plans or divide that money between them.

So who can profit from the Roth 401(k)? For starters, it can be a great move for anybody who shares the hoarding habits of the lowly squirrel.

Squirrels spend a lot of their time gathering nuts for the winters, which isn't much different than hard-core savers hoarding cash for their retirement years. The retirees with the most nuts stored up are more likely to get stuck with higher tax bills because they must begin withdrawing a percentage of their retirement assets shortly after reaching the age of 70 1/2.

Withdrawals in a Roth 401(k), however aren't taxed. And if you eventually transfer the cash in a Roth 401(k) into a Roth IRA, you can also sidestep mandatory withdrawals.

Other workers likely to benefit from the Roth 401(k) are lower- and middle-class workers who are currently in a low federal tax rate.

Those who should probably stick with a regular 401(k) include low-income workers, who pay no federal tax because they qualify for earned income and additional child tax credits. Plenty of financial experts have suggested that the Roth 401(k) won't be appropriate for those who retire into a lower tax bracket. Of course, many people expect a less-punitive tax bite after they quit work, but this can actually be a dangerous assumption.

To understand why, you have to look back over the changes to the tax structure during the past two decades. Since 1980, Vanguard researchers note, the top marginal federal tax rate has dropped from 70 percent to 35 percent. At the same time, tax brackets have broadened, the use of tax credits have spread, and the tax treatment on retirees' Social Security checks has changed.

These tax changes, the study suggests, have actually weakened the case for pretax savings because an increasing number of individuals now face the possibility of remaining in the same tax bracket in retirement or actually getting shoved into a higher one. If you pull out a sizable withdrawal from your 401(k) or traditional Individual Retirement Account, for instance, you could get hurled into a higher bracket. Plenty of affluent retirees are also horrified when they find their Social Security benefits getting taxed. Because the thresholds for taxing these benefits aren't indexed to inflation, more retirees will get dinged in the future. Vanguard provides an example of how retirees can get trapped in a higher tax bracket.

Researchers used the example of a married couple, making $80,000, who raised two children while working. The couple, who fell into the marginal 15 percent tax bracket during their careers, retired with 75 percent of their working income. They'd expect to stay in the 15 percent bracket, but thanks to the tax treatment on their Social Security checks, their effective tax rate jumps to 28 percent in retirement.

Ultimately, Vanguard suggests that many workers should invest in both types of 401(k)s for the tax diversification. None of us knows what's going to happen to tax rates in the future. But with current rates so low, if I were a gambler, I'd bet on more tax pain in the future.

Why not, then, keep some of your cash in a retirement plan where tax-bracket gyrations are irrelevant.

While acknowledging that uncertainties about future tax rates have kept some employers twiddling their thumbs, the report suggests that this procrastination can ultimately hurt employees. "Given the unpredictable nature of future taxes, many sponsors and participants are likely to be better off pursuing a strategy of tax diversification with the Roth 401(k) as soon as possible," according to the Vanguard research paper.

If you'd like a free copy of the 31-page research paper, titled "Tax Diversification and the Roth 401(k)," visit the Web site of the Vanguard Center for Retirement Research at www.vanguardretirementresearch.com. Better yet, give a copy to your employer.