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Spokane, Washington  Est. May 19, 1883

Pay now, save later

Russ Wiles The Arizona Republic

No workplace retirement plan is perfect. But some 401(k) programs will get a makeover next year that will remove a big wart.

Up until now, a main blemish for 401(k) plans has been a hefty tax bite on withdrawals. When people pull money out of these accounts, they must pay taxes as ordinary income, not at the lower capital-gains rates that otherwise would apply to long-term holdings.

Granted, 401(k) plans still have many benefits that make them attractive despite this imperfection.

Salary income that you contribute to a 401(k) program avoids taxation, and investment earnings grow on a tax-deferred basis.

Workers can invest automatically and conveniently through payroll deduction.

Most companies offering 401(k) plans ante up money on behalf of workers in the form of matching funds.

Still, the income tax bite on withdrawals is a drawback that has turned off some people to the 401(k) concept: Only 70 percent of eligible workers participate, researcher Hewitt Associates reports. But this tax issue will recede in importance starting Jan. 1, 2006.

That’s when employers can amend 401(k) plans to offer a new option that lets workers pull out money tax-free in retirement, if they’re willing to give up the front-end break.

This new option is called the Roth 401(k) in reference to Roth IRAs, which feature similar tax treatment. It would supplement rather than replace existing 401(k) plans.

“You won’t get the up-front tax benefits, but your distributions won’t be taxed,” said Nicholas Kaster, a senior pension-law analyst at researcher CCH Inc. “Think of a 401(k) plan with Roth-IRA features.”

Workers at firms with flexible rules will be able to split money between regular and Roth 401(k) accounts. Doing so would give investors two pots of money and more withdrawal options. For example, tapping a Roth 401(k) would be wise during years when income-tax rates are fairly high, while normal 401(k) distributions could make sense in years of low marginal rates.

Unlike private Social Security accounts and proposals to tweak existing IRAs, the Roth 401(k) idea isn’t merely in the planning stage or subject to debate. It was sanctioned by federal legislation in 2001, and the Internal Revenue Service issued guidelines last month.

Still, the concept isn’t widely known. “It has been flying under the radar,” Kaster said.

One question is how many firms will offer Roth 401(k)s. Those that adopt the plan will have to do more recordkeeping, because Roth money will need to be segregated from regular 401(k) balances.

In a fall survey of 200 large companies, about one-third said they planned to offer Roth 401(k) options, Hewitt said. Most 401(k) investors probably won’t choose the Roth version since it may be too painful to give up the front-end tax break. Still, plenty of people will like having a choice.