Adding Roth to 401(k) requires some planning

In the legal maze governing 401(k) retirement plans, few topics have generated as much discussion in recent years as the introduction of the Roth 401(k) feature.

Articles abound on whether an employer should add this new feature to its 401(k) plan and whether an employee should take advantage of this new tax-savings vehicle.

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Employers with 401(k) or 403(b) plans were able to add the optional Roth feature to their plans effective for plan years beginning after 2005. Employee contributions to the Roth 401(k) are made on an after-tax basis. Distributions from the account will be free from income tax provided the distribution is made after the participant reaches age 591/2 or in the event of his disability or death and his account has been in place for five years.

One survey suggests that fewer than 20 percent of employers intend to add the Roth feature, citing increased administrative complexity and employee education burdens as the top deterrents.

While employers may be slow to add Roth contributions to their plans, they may capitulate in time as employees begin to demand the feature. And, in that case, employee communications will be critical.

Her tax adviser confirms, based on her tax situation, what she concludes from the calculator: If she does not change her 401(k) savings rate, and so is willing to pay the extra taxes today, the Roth 401(k) will generally produce a better result. Her after-tax retirement income generated from Roth contributions will be higher than if she were to make the same amount of contributions on a pre-tax basis.

Now talk to another participant who is just beginning his career. He anticipates continued growth in his income such that he expects to be in a higher marginal tax bracket in his later years, including retirement. He calculates that he too can afford the extra taxes today, which may be minimal in the early stages of his career, that a Roth contribution will require. The Roth calculator suggests and his tax adviser agrees that Roth contributions over the course of his career will yield higher after-tax income in retirement than traditional, pre-tax 401(k) deferrals.

Should an employer yield to employee demand, which may come from just a few, the biggest challenge to implementing the Roth will be employee communication. Note in the above scenarios that the participants did not lower their contributions to the plan when switching to Roth. They were able to live on lower take-home pay. Opponents of the Roth 401(k) fear that many employees will not be able to afford this same decision. To compensate, employees will lower their Roth contribution to minimize the impact on their paychecks.

Employers should discourage this result. Participants may struggle to calculate the Roth contribution that equates to the same pre-tax contribution, resulting in lower Roth contributions than necessary. In addition, participants may select a contribution rate that puts them below the employer's maximum rate of match - a further loss of retirement dollars. And, worst of all for the employer, the lower contribution rate will adversely affect the special nondiscrimination test, known as the "ADP test" that limits 401(k) contributions by highly paid employees.

The decision to add Roth to an employer's 401(k) plan is not easy. Employees will push employers for the feature, while others will demand additional education to determine whether these contributions make sense for them in the long run.

Your retirement plan provider should be ready to assist you with implementation, including planning tools and employee communications.