Meet the new 401(k)

Your options for saving money for retirement are about to grow

The lure for participating in a 401(k) retirement plan is being turned on its head.

Since 401(k)s took off two decades ago to become the primary plans at many firms, the big attraction has been an immediate cut in income tax. The share of salary an employee directs to a 401(k) is excluded from taxable income, as are any matching contributions by the employer. Put $7,000 of a $70,000 salary into a 401(k) and you only report $63,000 of taxable salary to the IRS, an immediate payoff that can lead to a bigger tax refund when you file your return. It's when you make withdrawals of the deposits and the account's investment earnings that tax is due.

Starting Jan. 1, employers will be allowed to offer a new type of 401(k) that turns things around by letting you give up that immediate income tax break in exchange for tax-free withdrawals of deposits and investment income, generally speaking after age 59 1/2 and in retirement. So the entire $70,000 of salary in the above example would be taxable, even when you're contributing to a 401(k), which some savers could find a turnoff.

The new 401(k), set up by Congress to encourage savings by offering more choices, mimics the tax features of the Roth Individual Retirement Account. The traditional 401(k) will continue, and you can even split deposits between the old-style account and a Roth 401(k), as the new plan will be known. Employer matching contributions for either type, however, must by law go into a traditional 401(k), and be taxable upon withdrawal.

Employers who want to start the new 401(k) at the beginning of next year will start to enroll workers in the fall. So which one is better? It depends. Do you want to pay taxes now or later? Can you do with less money now so you can have more money in your nest egg later?

For some, the choice between the two accounts may be a tossup as far as long-term return is concerned. That's because both accounts can yield the same after-tax nest egg if your current and future tax-rate bracket is the same. But the Roth can pay off better if your tax rate rises and the traditional account can pay off better if your rate declines.

Roth 401(k)s can also provide more spendable income in retirement. The balance you see will be the balance you get since the nest egg won't be reduced by a tax bite.

''With a traditional 401(k) you can save tax now and maybe use that tax savings for current discretionary spending, perhaps to take a vacation, but with a Roth you can have the freedom of withdrawing money tax-free any time you want after you retire," says Boston financial adviser Paula Chauncey, who operates as Etre LLC.

The future reward of a Roth 401(k) may resonate with baby boomers who can afford to save big in order to avoid living in retirement with a substantially reduced income, says Kevin Queally, an adviser at Merrill Lynch in Wellesley. ''Paying tax upfront can help these people build up a larger amount of after-tax assets to tap," he says.

Someone who puts the maximum of $15,000 into a regular 401(k) next year, for example, and enjoys investment gains that push the balance to $30,000 will net $22,500 after paying tax when the money is withdrawn, assuming a 25 percent tax rate. Someone in the same situation who puts $15,000 into a Roth, however, ends up with a net of $30,000 since there is no tax on the withdrawal. The price for that larger nest egg is that this person must come up with the money to pay tax on that $15,000 of salary contribution.

The decision to open a Roth 401(k) may depend on your expectation of future tax rates. When traditional 401(k)s were introduced it was assumed that many people would fall into a lower tax bracket when they retired. So it made sense to exclude current income from high tax rates and allow withdrawals to be taxed at a lower rate in the future. But cuts in tax rates and a reduction in the number of brackets since then make it more likely that many retirees will not fall into a lower rate bracket.

Young savers with modest income or paying little tax in the early stages of a career and family could find the current tax savings from a traditional 401(k) small. A potentially bigger payoff could be future tax-free savings from a Roth payout after their assets have grown, advises Lori Lucas, director of participant research at Hewitt Associates, a benefits consultant headquartered in Lincolnshire, Ill.

''Depending on your political and economic outlook, you might even expect that overall tax rates will be higher in the future," she says, a plus for paying tax earlier with a Roth.

For some high-income people a Roth 401(k) can be an estate-building tool. After leaving your employer, the funds in a Roth 401(k) could be rolled over into a personal Roth IRA, which unlike a traditional IRA does not require gradual withdrawals after age 70. With a Roth IRA the funds can sit untouched as a legacy to heirs.

The annual limit on deposits to a Roth 401(k) will be the same as for a regular 401(k). For 2006 that's as much as $15,000 for those under 50 and $20,000 for those 50 or older, not counting an employer's matching contributions. If you divert wages into both a Roth and a regular 401(k) the combined total can't exceed those caps.

About 35 percent of large firms surveyed earlier this year by Hewitt Associates said they were very or somewhat likely to set up a Roth 401(k) to enhance their menu of benefit options to employees. But many firms remain undecided and others have been keeping their plans under wraps until they can tell their employees. An estimated 42 million workers were participating in 401(k) plans at the end of 2003, with an average balance of almost $77,000 among a sampling of consistent savers, according to a joint survey by the Employee Benefit Research Institute, which reports on worker benefits, and the Investment Company Institute, the mutual fund industry's trade group.

Some firms may delay implementation because of administrative burdens, uncertainty over employee response, unanswered technical questions, and the fact that deposits to Roth 401(k)s won't be allowed after 2010 unless Congress extends the law permitting that option.

Financial advisers say employees who would like the Roth option may want to let their benefits department know of their interest. But though many benefit specialists welcome the Roth 401(k) option they worry about adding new decisions to an area that many employees already find confusing.

''Fewer people may choose to take part the more complex these plans get," cautions Martha Priddy Patterson, a benefits policy analyst in the Washington, D.C., office of Deloitte Consulting.