401(K) Plans

Related Terms: Employee Benefits; Retirement Planning

A 401(k) plan is a tax-deferred, defined-contribution retirement plan. The name comes from a section of the Internal Revenue Code that permits an employer to create a retirement plan to which employees may voluntarily contribute a portion of their compensation on a pre-tax basis. This section also allows the employer to match employee contributions with tax-deductible company contributions, or to contribute additional funds to employee accounts at the company's discretion as a form of profit-sharing. Earnings on all contributions are allowed to accumulate tax-deferred until the employee withdraws them upon retirement. In many cases, employees are able to borrow from their 401(k) accounts prior to retirement at below-market interest rates. In addition, employees may decide to roll over funds in their 401(k) accounts to another qualified retirement plan without penalty if they change jobs.

Popularity of 401(k) plans during the 1990s and 2000s has been great. For the first time ever, in 1997, 401(k) type defined-contribution plans surpassed the more traditional defined-benefit pension plans in terms of the total retirement assets held by each. And the growth of defined-contribution plans continued thereafter. According to the Employee Benefit Research Institute, as of the close of 2005, defined-contribution plans held 61 percent of private-sector retirement assets, compared with 39 percent in defined-benefit pensions. The 401(k) plan has a reasonably short history yet it has already changed the face of retirement planning in America.

HISTORY

The 401(k) provision was created in 1978 as part of that year's Tax Revenue Act, but went largely unnoticed for two years until Ted Benna, a Pennsylvania benefits consultant, devised a creative and rewarding application of the law. Section 401(k) stipulated that cash or deferred-bonus plans qualified for tax deferral. Most observers of tax law had assumed that contributions to such plans could be made only after income tax was withheld, but Benna noticed that the clause did not preclude pre-tax salary reduction programs.

Benna came up with his innovative interpretation of the 401(k) provision in 1980 in response to a client's proposal to transfer a cash-bonus plan to a tax-deferred profit-sharing plan. The now-familiar features he sought were an audit-inducing combination then—pre-tax salary reduction, company matches, and employee contributions. Benna called his interpretation of the 401(k) rule "Cash-Op," and even tried to patent it, but most clients were wary of the plan, fearing that once the government realized its tax revenue-reducing implications, legislators would pull the plug on it.

Luckily for Benna and the millions of participants who have since utilized his idea, the concept of employee savings was gaining political ascendancy at that time. Ronald Reagan had made personal saving through tax-deferred individual retirement accounts, or IRAs, a component of his campaign and presidency. Payroll deductions for IRAs were allowed in 1981 and Benna hoped to extend that feature to his new plan. He established a salary-reducing 401(k) plan even before the Internal Revenue Service had finished writing the regulations that would govern it. The government agency surprised many observers when it provisionally approved the plan in spring 1981 and specifically sanctioned Benna's interpretation of the law that fall.

401(k) plans quickly became a leading factor in the evolving retirement benefits business. From 1984 to 1991, the number of plans increased more than 150 percent, and the rate of participation grew from 62 percent to 72 percent. The number of employees able to participate in 401(k) plans rose to more than 48 million by 1991 from only 7 million in 1983, and Benna's breakthrough earned him the appellation "the grandfather of 401(k)s." As expected, the government soon realized the volume of salary reductions it was unable to tax and tried to quash the revolution—the Reagan administration made two attempts to invalidate 401(k)s in 1986—but public outrage prevented the repeal.

The advent of 401(k) plans helped effect a philosophical shift among employers, from the provision of defined-benefit pension plans for employees to the administration of defined-contribution retirement plans. In the past, companies had offered true pension plans that guaranteed all individuals a predetermined retirement benefit. But after 1981, rather than providing an employer-funded pension, many companies began to give employees the opportunity to save for their own retirement through a cash or deferred arrangement such as a 401(k). This change helped level the playing field for small businesses, which were now able to offer the same type of retirement benefits as many larger employers. Small businesses thus found themselves better able to attract and retained qualified employees who may previously have opted for the security of a large company and its pension plan.

THE BASICS OF 401(K) PLANS

In benefits parlance, employers offering 401(k)s are sometimes called "plan sponsors" and employees are often known as "plan participants." Most 401(k)s are qualified plans, meaning that they conform to criteria established in the Economic Recovery Tax Act of 1981 (ERTA). ERTA expanded upon and refined the Employee Retirement Income Security Act of 1974 (ERISA), which had been enacted to protect participants and beneficiaries from abusive employer practices and created guidelines that were intended to ensure adequate funding of retirement benefits and minimum standards for pension plans.

Basic eligibility standards were set up with this legislation, though they have changed frequently since and may vary slightly from plan to plan. As of 1996, an employee had to be at least 21 years of age and have put in at least one year of service with the company to participate in the 401(k) program. Some union employees, nonresident aliens, and part-time employees were excluded from participation.

401(k) plans incorporate many attractive features for long-term savers, including tax deferral, flexibility, and control. Taxes on both income and interest are delayed until participants begin receiving distributions from the plan. Rollovers (the direct transfer of 401(k) funds into another qualified plan, such as a new employer's 401(k), an IRA, or a self-employed pension plan)—as well as emergency or hardship loans for medical expenses, higher-education tuition, and home purchases—allayed participants' fears about tying up large sums for the long term. While there are restrictions on these loans' availability, terms, and amounts, the net cost of borrowing may be quite reasonable because the interest cost is partly offset by the investment return.

Employees may also receive lump sum distributions of their accounts upon termination. If an employee elects to take his or her distribution in cash before retirement age, however, the employer is required by law to withhold 20 percent of the distribution. If the account is rolled over into another qualified plan, nothing is withheld. Employees' self-determination of investments has allowed tailoring of accounts according to individual needs. For example, younger participants may wish to emphasize higher-risk (and potentially higher-return) investments, while employees who are closer to retirement age can focus on more secure holdings. These features have been refined over the years through legislation, especially after the government realized the tax revenue losses engendered by the popular plans.

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