Harvest a rich 401(k)

(Money Magazine) -- From the outset, the 401(k) plan has been all about accumulating money, and when you think about your plan during your working life, you concentrate on how much to contribute and what mutual funds to invest in.

Unless you're retired, you probably haven't a clue how you'll withdraw your money, and you've never been offered any official guidance on how to convert your savings into retirement income.

Well, that's changing.

Recently it has been dawning on the folks who design 401(k)s that the ultimate goal of the plans is to provide a living income in retirement. And that the best time to start planning for that eventuality is when you put the money in. The result is two new 401(k) investment options that may show up in your plan soon.

When you tap your 401(k), Uncle Sam gets the first bite: Your withdrawals are taxed at ordinary income rates, which today run as high as 35%.

The new Roth 401(k) changes that. Since Congress gave the Roth a permanent green light in 2006, a growing number of companies have started offering employees a choice between a regular 401(k) plan and a Roth.

Pamela Hess, director of retirement research at Hewitt Associates, estimates that about 25% of companies have already adopted the Roth 401(k), with more to come. "In a couple of years I think we'll see the majority of plans offering it," says Hess.

The Roth 401(k) is a mirror image of a regular 401(k). Instead of getting an up-front tax break on your contributions and an income tax bill on your withdrawals, you pay tax on the money you contribute but none on the money you take out.

You can contribute to both a regular and a Roth 401(k) in any given year, as long as your total contributions don't exceed the annual limit ($15,500 for 2007 or $20,500 if you are 50 or older).

Each version will come with the same investment choices, but if you decide to invest in both a Roth and a regular 401(k), your company will set up a separate account for each.

The Verdict It's pretty simple: For most people, the Roth 401(k) is the better choice. If you're just starting your career, it's practically a slam dunk, says Don Weigandt, an adviser at J.P. Morgan's private bank.

Yes, you'll forfeit the up-front tax savings. But when you retire decades from now, you'll almost certainly be in a higher bracket, making the Roth's tax-free withdrawals far more valuable than any deduction today.

Even if you're mid-career, the Roth is likely your best bet. Here's why: Suppose you're earning a low-six-figure income and you contribute $15,500 to your 401(k) this year. Assume further that you'll earn an 8% annual investment return and that you'll be in the 28% federal tax bracket both before and after retirement. Put your money in a Roth 401(k) and you'll end up with $72,245 tax-free in 20 years.

Now suppose that you put the same $15,500 in a regular 401(k) instead. In 20 years the plan will net you $52,016 after you've paid taxes on the withdrawal - or $20,229 less than you'd have in the Roth.

But when you contributed, you also got to shelter $15,500 from taxes, which in this case gave you $4,340 more in take-home pay. (The lack of that tax break is why you'll see your paycheck shrink if you switch to a Roth.) If you were disciplined enough to invest that extra money, you'd still fall short of the Roth's total. Why? Because to close the gap you'd need to earn 8% after taxes - a tall order over time.

Still, a regular 401(k) can win out in some cases. If you're close to retirement and fairly certain that your income will drop noticeably once you stop working, skip the Roth. Likewise, if you plan to move from a high-income-tax state like California or Minnesota to one with low (or no) income taxes, such as Florida or Nevada, nab the tax savings today.

Not sure where you'll stand? Use the Roth calculator at dinkytown.com. Or hedge your bets by splitting your money between a regular and a Roth 401(k). Bear in mind that your employer match will be in pretax dollars and taxed at withdrawal no matter which 401(k) you choose.

If you want guaranteed income in retirement, you can buy an immediate fixed annuity when you stop working and get a check a month for life. Or with a new 401(k) option known as a fixed deferred annuity, you can put together that check bit by bit throughout your career.

With these options - recently introduced by insurers like MetLife and The Hartford - each of your 401(k) contributions buys a dollar amount of retirement income, which varies based on your age and interest rates when you invest.

For every $100 a 40-year-old saves today in MetLife's Personal Pension Builder, for example, he would receive $26.40 a year for life starting at age 65. To date, only a handful of employers have rolled out such annuities, but they are expected to be widely available in a few years.

What's to like Converting 25% or so of your savings into a predictable income can keep you from outliving your money (for more on this strategy, see "Make Your Money Last a Lifetime"). Right now the only way to do that is to spend a hundred thousand dollars or more on an immediate annuity at retirement.

Only problem: It's psychologically impossible to do. When employers offer retiring workers the chance to buy an immediate annuity, according to Hewitt, only 1% take them up on it. That's understandable. "Who wants to part with $100,000 or $200,000?" says Jody Strakosch, national director for MetLife Institutional Income Annuities.

That's where these new deferred annuities come in. By letting you annuitize in small increments over time, they help you get over that psychological stumbling block.

Buying an annuity gradually can also add up to a better deal than you would get by annuitizing at age 65. "One of the advantages is that you lock in an income stream that might cost you a lot more later on," says Moshe Milevsky, an annuities expert at York University in Toronto.

The most important variable when you buy an annuity is interest rates: The higher rates are, the greater your eventual income will be, and vice versa. So building an annuity over time can blunt the risk of annuitizing all at once when interest rates might be low.

Annuities have also been getting more expensive in general because Americans are living longer. Milevsky estimates that increased life expectancies have boosted the cost by some 20% over the past two decades. Start buying now and you may pay less than you would when more longevity gains push prices up even more.

What's not to like The biggest glitch with fixed deferred annuities is that they aren't portable. If you change jobs, you can't roll them into an IRA and keep up contributions, thus defeating the advantage of investing gradually over time. And odds are good that your next employer's 401(k) doesn't offer the same annuity yet.

The verdict If you think you'll be staying with your employer for several more years and you don't have a traditional pension, 401(k) annuities are worth a look. Allocate no more than 20% to them, in lieu of some of your fixed-income holdings. Put the rest of your 401(k) to work in low-cost stock and bond funds. That way you'll be reaping the fruits of both growth and guaranteed income when 401(k) harvest time arrives.