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Should Your Business Offer A Roth 401(k)?

A new type of retirement plan debuts in 2006: the Roth 401(k). Created by a 2001 tax act, the new plan is a hybrid that marries features of traditional 401(k)s and Roth individual retirement accounts. Important features of the Roth 401(k) include:

If you own a business, you'll now have the option of including a Roth 401(k) among your company's retirement-plan options. But should you?

It may depend in part on whether the option would benefit your own retirement savings. Much hinges on your current and future tax brackets. As a rule, if you don't expect your tax rate to change between the time you make contributions and the time you begin withdrawals-or if you think your bracket may be lower later-the traditional 401(k) should be preferable, because of tax-deferral on the salary you contribute. Given the time value of money, it's better to pay the same tax down the road than to give it to the IRS today.

But what about taxpayers who may face a higher bracket in the future? That could include a young worker whose career has yet to blossom, or perhaps a child you employ. Or it could be someone who has significant assets in tax-deferred accounts that will have to be withdrawn-and taxed-during retirement. In those cases, paying tax now on Roth 401(k) contributions makes sense, because it helps avoid a bigger IRS bite when withdrawing money.

There's also the chance that Washington could decide that everyone's future tax rates should be higher. Today's brackets are at historical lows, and it's no secret that the federal government is racking up gargantuan budget deficits. Some economists believe a general increase in tax rates is inevitable. That scenario favors the Roth 401(k).

Another consideration is the potential taxation of Social Security benefits. Depending on your retirement income, some but not all of these payments are taxable. Working out just how much you might have to pay is complicated, but anyone with a six-figure retirement income could end up paying income tax on as much as 85% of total Social Security benefits. If you expect your earnings in retirement to trigger such taxes, you may do better with a Roth 401(k), because its tax-free withdrawals won't count as income.

Beyond the question of the benefits a Roth 401(k) might bestow on you and family members who work in your business, there are potential costs to consider before adding the new account to your company's benefits package. For one thing, you'll have to pay to have your existing 401(k) plan amended so it can accept after-tax contributions. For another, annual plan administration may be more costly if you offer both kinds of 401(k)s, because you'll have to maintain separate records of participants' pre-tax and after-tax contributions and the investment earnings each generates. Finally, when unveiling the new plan to your workers, you could face the additional expense of educating them about potential benefits and pitfalls.

Keep in mind, too, that as the law now stands, a Roth 401(k) will be able to accept contributions for only five years. The 2001 legislation that created these plans is subject to a sunset provision that repeals the entire act after 2010, unless Congress acts to extend it. Most observers interpret this to mean that Roth 401(k)s in existence at that time won't have to be terminated, but neither will they be able to accept further contributions. On the other hand, if the Roth 401(k) catches on in a big way before then, Washington might decide to change the rules to allow continuing contributions.

For all 401(k)s, contributions in 2006 are generally limited to a total of $15,000-or $20,000, if you're 50 or older and your company allows catch-up contributions. Workers who have the Roth option may split their maximum contribution between the two plans. But matching contributions from employers must go into a traditional account.

So what should your company do? Experts are still sorting out the pros and cons of both kinds of 401(k), and there could be rule changes ahead as the IRS considers the new savings vehicle. In the meantime, if the costs aren't prohibitive, you may want to consider adding the Roth option simply as a way for you and your employees to hedge your bets, diversifying the tax exposure of your retirement assets.

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