Click here to return to "In Our Own Words"

GETTING PERSONAL: Future Taxes Make 401(k) Less Advantageous

By Jilian Mincer
A DOW JONES NEWSWIRES COLUMN

NEW YORK (Dow Jones)--The expectation of higher taxes is taking some of the shine off 401(k) retirement plans, and has savers looking for more post-tax options.

Since 401(k)s were created in the early 1980s, the general assumption was that a saver would pay lower taxes in retirement, when their income was certain to be lower. So saving pretax dollars and delaying taxes made sense. Now, particularly for higher earners with the largest 401(k) balances, that assumption is fading as hikes in tax rates seem likely.

"People are pretty much convinced that they have to do something," says Robyn Credico, national director of defined contribution consulting at Watson Wyatt.

In response, more employers are considering offering a Roth 401(k)s, to which workers contribute post-tax earnings and get to enjoy tax-free growth of their money, she says. Businesses also are looking at allowing "in service withdrawals" from their traditional 401(k)s, so that employees can roll the money into a Roth IRA in 2010 and pay taxes at current rates, spreading the bill over two years.

"There's a huge case to make for tax diversification, because at some point taxes will be higher and at some points it will be lower," says Jean Young, senior research analyst at the Vanguard Center for Retirement Research.

She says one problem high earners may face by saving only in a pretax 401(k) is that, years later, large withdrawals could trigger the tax on Social Security.

Employers initially were reluctant to add the Roth 401(k) plan because its tax benefit wasn't permanent until very recently. The plans also could require more paperwork and participant education.

Because the contributions are after taxes, workers have to be willing to commit more of their current income to the Roth 401(k) plans. For example, someone in the 33% tax bracket would have to pay $8,127 in taxes before making the maximum $16,500 Roth 401(k) contribution, according to Vanguard.

Still, the plans have been growing in popularity with professionals who may be getting tax and financial advice, says Dean Kohmann, Charles Schwab vice president of 401(k) services.

More than half--52%--of Schwab's work place retirement plans now offer the Roth 401(k), up from 46% last year. About 70% of the plans at professional firms provide the Roth, and about half of those employees at those firms use them--a much higher rate than the national average.

Michael Doshier, vice president of Fidelity's Workplace Investing group, says the Roth 401(k) is a good choice for higher earners whose income isn't likely to fall in retirement and for young investors, who will likely see their salaries and taxes increase.

But if someone doesn't have a Roth, financial advisers encourage them to save at least until the company match in the traditional 401(k) no matter what their tax bracket. If they meet income restrictions, individuals could then contribute to a Roth IRA before making additional contributions to the 401(k).

Cheryl Holland, a financial adviser in Columbia, S.C., reminds clients to put tax-efficient products such as ETFs and municipal bonds in non-tax-deferred accounts because "it's asset location as well as asset allocation."