Q. My husband's 401(k) plan is with a small company. His only fund choices have high expense ratios and do not perform well relative to their peers. Several are heavy in tech stocks. Examples are: Alliance Tech Fund, expense ratio 2.31%, Aim Charter, expense ratio 1.86%, Merrill Lynch Intermediate Bond, expense ratio 1.38%, Oppenheimer Quest Opportunity, expense ratio 2.11%, and so on. His company match is only 1%.

Since his choices are so poor and high fund expenses eat up the company match, would we be better off opening a Roth IRA instead? I believe that we'll be in the same 27% tax bracket when we retire in 35 years. On the other hand, the 401K contributions reduce our taxes significantly.

Another option we've considered is maxing out my 401K with the money we would have put in his. I contribute 10% of my pay ($7,000), and he contributes 15% of his pay ($5,000). We could put an extra $4,000 in mine and put the extra $1,000 in a Roth. I'm just not sure about mingling assets like that. I'm not planning on getting divorced, but it leaves a large 401(k) liability on my part if we did get divorced.

So should we keep the money in his 401K, switch to a Roth, or contribute extra to my 401(k) and put the excess into a Roth?

------ C. G., by e-mail from McKinney, TX

A. You're right on the mark. Switching to a Roth for some of your savings is a good idea. The automatic saving feature of 401(k) plans makes them very attractive. Unfortunately, some plans are so poorly constructed they aren't worth shooting. Your husband's plan is a good example. The combination of high fees and low employer match is deadly.

In my opinion every plan should have the option of a low cost equity index, a low cost fixed income index, and an inflation protected option such as a Treasury Inflation Protected Securities fund. He should stop contributing immediately. He should let his employer know why. In fairness to his employer, small company 401(k) plans tend to be expensive.

Of the four funds you mentioned, only one ranked in the top half of its competitive peers over the last 5 years. Oppenheimer Quest Opportunity, according to fund watcher Morningstar, was in the 45th percentile. The Alliance fund was in the 58th percentile over the same period, the AIM fund was in the 66th, and the Merrill fund was in the 80th percentile. As I've said many times, high fund expenses are a major contributor to poor performance.

While your current tax bill will go up if he stops participating, switching to a Roth IRA will allow you to skirt the issue of your future tax rate will be higher than your current tax rate. You'll be building an account where all withdrawals are tax-free.

This is important because an increasing number of people are being taxed on their Social Security benefits when they retire. As I have shown in a number of recent columns, current retirees can put 73 cents of purchasing power into a 401(k) plan this year but take out only 50 cents of purchasing power next year when they retire. This happens because the effective tax rate on their withdrawals can be as high as 50 percent. That's nearly twice the 27 percent rate many families are trying to avoid when they contribute to a 401(k) plan. This tax affects more people every year.

"Does Participating in a 401(k) Raise Your Lifetime Taxes?" by economists Jagadeesh Gokhale, Laurence J. Kotlikoff, and Todd Neumann, showed that workers with incomes under $100,000 were likely to suffer an increase in lifetime taxes and a reduction in lifetime consumption as a result of participating in a 401(k) plan.

Why? Success in the 401(k) plan would cause their Social Security benefits to be taxed.

This means most working Americans need to broaden the base of their retirement security. A rough rule of thumb is that employees with typical 401(k) plans--- which include a 50 percent match--- should "capture the match." Then they should switch to a Roth IRA. In your case, that's also a good reason not to 'double up' and put more into your 401(k) plan.

The original research paper is available on Professor Kotlikoff's website, http://econ.bu.edu/kotlikoff/. The National Center for Policy Analysis in Dallas has a shorter version on its website. It has very clear recommendations about the use of Roth IRA accounts. Readers can access it by visiting www.ncpa.org, clicking on publications, and downloading publication #249, "Tax Favored Savings Accounts: Who Gains, Who Losses."

Related Columns:

February 11, 2003----Torpedo Tax Causes a Sinking Feeling

February 18, 2003----Don't Get Caught in Early Retirement Tax Trap