Introducing the Roth 401(k)

On Jan. 1, the U.S. government will allow businesses to offer employees a new retirement option ­ the Roth 401(k).

The new Roth 401(k) plan combines features of a traditional Roth IRA account with those of regular 401(k) account. This new program enables employees to contribute after-tax dollars to their retirement funds in place of, or as part of, their percentage of contributions. The advantage of an after-tax contribution is a tax-free withdrawal of the contributions and their earnings at retirement.

Although this plan has such benefits, it is important to understand what is involved when implementing a Roth retirement package. With so many retirement options to choose from, education regarding the effects this program can have for businesses and employees is of paramount importance.

The Pros

From an employee perspective, the greatest advantage of the new Roth 401(k) is that no income taxes will ever be paid on the earnings for these contributions. Moreover, it also provides an avenue for individuals with extra cash for investment, or those near retirement, to add to or build up their savings. Unlike a traditional 401(k), the Roth option enables a person to roll their account into a Roth IRA that doesn¹t have minimum distribution amounts at age 70. Because of these benefits, it is easy to understand why a Roth 401(k) might be an attractive retirement option for certain investors.

From an employer¹s point of view, the biggest benefit is easy to see. Since there is no additional cost to add a Roth option to a 401(k), other than a plan amendment, employers can add a benefit without any major hassles. The Roth 401(k) enables employers to broaden their retirement options and help their employees save for retirement at no real cost.

The Cons

Despite these benefits, businesses and employees need to be aware of some of the changes created by a Roth plan. For example, employees need to realize
that participation is with after-tax dollars and will affect their weekly take-home pay. Contributions made to a regular 401(k) are pre-tax, which means you get the benefit of investing your money before the government gets its cut.

With the Roth 401(k), any monies you contribute will have already been taxed. Because of this, employees need to make sure that it makes sense mathematically for them to participate. After retirement, most people will find themselves in a lower tax bracket because they no longer have an income from a job. Why pay taxes now when you are in a higher tax bracket, which is what the Roth 401(k) requires, versus in retirement when your tax bracket is likely to be lower? For example, a pre-tax investment of $15,000 requires you to earn $15,000. However, when utilizing an after-tax plan, you will need to earn $25,000 (assuming a 40% tax bracket) to make the same contribution.

Businesses also face a significant issue when utilizing a Roth 401(k). Employers have a fiduciary responsibility to educate their employees about the risks and rewards of their retirement offerings. That process is already difficult, but now businesses will be required to communicate the advantages and disadvantages of pre-tax and after-tax contributions which, if not done effectively, could create confusion. This uncertainty might reduce overall participation by employees because they may not feel well enough informed to make a decision. Also, as the implementation of these Roth plans has never been done before, there could be challenges for the testing and administration of these plans.

Making the Roth Choice

Since the Roth 401(k) plan is currently only in effect until 2011, many businesses might decide against offering it because it could be repealed after only six years. However, if they do decide to make this extra benefit available, there are clearly some individuals who might benefit from a Roth 401(k) package, especially those who have extra cash to invest in their retirement.

As always, the key to any retirement plan is moderation and diversification. Therefore, it is important for businesses and employees to fully understand their options before making any decisions.

Aviva Sapers is the CEO of Sapers & Wallack, an asset management firm specializing in insurance and benefits planning; (617) 225-2600.