Roth 401k -- Meet one dissenter from Roth 401(k) rah-rah chorus

ROBERT POWELL

Lone wolf

Meet one dissenter from Roth 401(k) rah-rah chorus

By Robert Powell, MarketWatch

Last Update: 8:40 PM ET Apr 4, 2007

BOSTON (MarketWatch) -- To many, the newly introduced Roth 401(k) is the greatest retirement account (along with the Roth IRA) ever created. With a Roth 401(k), one contributes after-tax dollars into an employer-sponsored retirement account in which the money grows (as it does in a traditional IRA) tax-free and (unlike a traditional IRA) is distributed tax-free too.

But while many experts praise the benefits of Roth 401(k)s, there's a lone wolf out there with a contrary point of view, penning articles under such headlines as "Roth 401(k): Dumb and Dumber" and "Roth 401(k): Still Dumber."

What doesn't Lawrence Starr, president of Qualified Plan Consultants, like about Roth 401(k)s? Let us count the reasons.

For starters, Starr says workers have to evaluate which is better from a tax standpoint -- the Roth 401(k) or the traditional 401(k). Typically the experts, including Starr, say that workers who are in a low tax bracket when they contribute to a tax-deferred retirement account and expect to be in a higher tax bracket when they withdraw their funds are better off using a Roth account.

But, according to Starr, very few fit into this category. Those include young workers with little or no income, those in a low income tax bracket because of large deductions for child care and homeownership or those whose income will be significantly higher in retirement.

Most workers, he says, will likely be in a lower or the same tax bracket when they retire. And those folks, he says, are better off with the current tax deduction, the traditional 401(k) contribution.

Yes, there are some experts (and regular Americans as well) who say that tax rates are historically low and are likely to rise over time. And given that prediction, the experts say workers should give up the current tax deduction in the hopes that tax rates will be higher later on.

"That is what I call a dumb solution," wrote Starr in the Journal of Pension Benefits. "The (worker) has to give up a sure thing (the current deduction) for what is just a chance that the future benefit will be more valuable -- dumb move, if you ask me."

Do you trust Congress?

Starr is also not fond of Roth-type accounts for this reason: Congress, he predicts, will likely change the laws in midstream and tax Roth distributions at some point. What's more, he predicts that Congress won't even give Roth account owners the courtesy of being grandfathered.

"We have to count on Congress not to change the laws between now and then that provide Roth-type distributions are tax free," he wrote. And that, he says, is just not a "wise bet" anytime.

Consider, he notes, how Congress has often changed tax laws once thought to be unchangeable. For instance, Congress decided to tax up to 50% of Social Security benefits and no one had the luxury of being grandfathered.

For Roth contributions to be better than traditional 401(k) contributions, you have to give up the deduction in hand, hope to be in a higher tax bracket when you take the money out of the retirement account and hope that Congress doesn't change the rules in between. Says Starr: "There are just too many unknowns for this decision to be sensible for most people."

To be fair, Starr does say Roth IRAs have one big advantage over traditional IRAs. With a Roth IRA, he says, account owners never have to take a required minimum distribution as do owners of traditional IRAs and they can contribute to a Roth IRA well past the usual cut-off age of 701/2. "So, substantially more assets can be socked away for oneself and one's heirs," he wrote.

But in the main, Starr says there are other devil-is-in-the-details issues that make Roth-type accounts dumb and dumber. For instance, workers who contribute to a Roth 401(k) will have a higher adjusted gross income than if they put the money in a traditional 401(k) and that could result in the loss of other tax benefits that have phase out limits, such as child-care tax credit. In addition, a higher adjusted gross income could bring the alternative minimum tax into play.

In addition, it's not yet known how Roth 401(k)s will affect divorce agreements that split retirement accounts in two, the Qualified Domestic Relations Order or QDRO. The lawyers will have to calculate the net present after-tax value of the Roth 401(k) and the traditional 401(k).

Plus, there are some questions about the death benefits when there are multiple beneficiaries and Roth and traditional 401(k) accounts. Will someone get the account with the taxable distributions and someone get the account with the tax-free distributions?

Headaches for employers

What else? Well, for employers, especially small businesses, the problems with Roth 401(k)s are many. For one, small business owners would have to change what's called summary plan documents, adding the Roth option. Payroll records would have to be modified.

Plus, the plan's service provider would need to put in place separate tracking and record-keeping for the Roth and traditional 401(k) contributions. And the costs associated with those activities are not insignificant, Starr says.

"These small businesses don't have a personnel staff" as do large employers, he said. What's more, employers must establish rules for hardship distributions and participant loans.

And last, Starr notes that small-business owners will have the unenviable task of trying to educate workers about Roth 401(k)s. And on this point, he says, the center does not hold.

"Employee communication which is already overwhelming many plans and participants, is going to find a significant new challenge in explaining the Roth 401(k) plan in a manner that is easy to understand for employees," he wrote. "Good luck."

Robert Powell has been a journalist covering personal finance issues for more than 20 years, writing and editing for publications such as The Wall Street Journal, the Financial Times, and Mutual Fund Market News.