401(k) plans begin
401(k) plans are employer-sponsored retirement savings accounts that allow employees to allocate a portion of their salaries into investment accounts on a pre-tax basis. The concept originated from the Revenue Act of 1978 but gained prominence with IRS regulations issued in 1981, which provided guidelines on how the plans operate. Unlike traditional savings plans that utilized after-tax dollars, 401(k) plans enable funds to grow tax-deferred until withdrawal, encouraging greater retirement savings among employees. Many companies, including prominent firms like Johnson & Johnson and PepsiCo, adopted these plans rapidly, often replacing traditional pension plans. By the mid-1980s, over 97,000 companies offered 401(k) plans, covering millions of employees and significantly increasing total investment assets. While participation in 401(k) plans is voluntary, they have become a popular choice for employees seeking financial security for retirement. However, 401(k) plans do not guarantee benefits like traditional pensions, which can introduce investment risks depending on market fluctuations. Despite this, they have played a critical role in shaping retirement savings in the U.S., benefiting both employees and the stock market through increased investment activity.
401(k) plans begin
Tax-deferred retirement savings programs
Date Began November 10, 1981
The 401(k) plan was named for the section of the Internal Revenue Code that governs it. It allows employees to defer paying taxes on a portion of their income that they invest toward retirement. The money in the resulting investment portfolio—including accrued interest—is taxed only when it is withdrawn.
The history of the 401(k) plan dates back to the Revenue Act of 1978, which added section 401(k) to the Internal Revenue Code. That law went into effect on January 1, 1980. However, the birthday of the plan is typically celebrated to coincide with the November 10, 1981, issuance by the Internal Revenue Service (IRS) of Regulations on the Plan, which explained the 401(k) system and how to take advantage of it. Under the employer-sponsored 401(k) plans, employees could elect to have a portion of their salaries deducted from their paychecks and deposited directly into retirement investment accounts. Many companies had previously sponsored such savings plans, but those plans typically involved the use of after-tax dollars. The 401(k) law, by contrast, allowed employees to save for retirement using before-tax dollars. As a result, funds would accumulate faster, because the original contribution and subsequent earnings on the plan were all tax-free until they were withdrawn after retirement. Employees were motivated to save more for retirement, and the stock market benefited from the increased funds available for investment.
Operational Details of the Plans
The new retirement plans were viewed as a good deal for employees, so many large companies, such as Johnson & Johnson, PepsiCo, and JC Penney, quickly implemented 401(k) plans. For many companies, the implementation date was January, 1982. Within two years, about half of all large American companies had 401(k) plans in place. At many companies, the plans replaced traditional pension plans, which provided guaranteed income upon retirement. To sweeten the shift to this new and riskier type of retirement plan, and to make the new plans more enticing to employees, companies often agreed to match employees’ contributions. Initially, the law allowed each employee to defer up to $45,475 of salary each year, but that amount was reduced to $30,000 in 1983 and remained at that level throughout the rest of the decade. By 1984, the Internal Revenue Code had been revised to require nondiscrimination tests to assure that 401(k) plans applied equally to all employees, rather than being provided only to highly paid employees and managers. By 1984, there were over 17,300 companies with 401(k) plans, covering more than 7.5 million employees. Total investments in these plans were valued at $91.75 billion.
The Tax Reform Act of 1986 tightened the nondiscrimination rules. By the end of the decade, there were over 97,000 companies with plans, covering 19.5 million employees. Assets totaled over $384 billion. Congress had finally found a motivating factor to encourage employees to save money for retirement, although not all employees participated in the plans, which were voluntary. Although 401(k) plans were available only to employees of for-profit businesses, similar plans called 403(b) plans were made available to employees of nonprofit organizations and educational institutions.
Although employers were made responsible for establishing and administering the plans, that task was typically outsourced to financial services companies, such as mutual funds or insurance companies. When employees moved to new employers, they were given the option of transferring, or “rolling over,” their existing retirement plans to similar plans administered by the new employers.
The tax code established restriction on preretirement withdrawals from 401(k) plans. Unless an exception applies, an employee’s 401(k) funds must remain in the plan accounts until the employee reaches the age of fifty-nine and one-half years. If money is withdrawn prior to this age, the employee must pay a 10 percent penalty tax, in addition to the normal taxes. Some plans do allow employees to borrow money from their retirement plans, but such loans must be paid back with interest prior to retirement.
Impact
The explosive growth in the number of 401(k) plans throughout the 1980’s was at least partly attributable to their low cost to employers. Such plans were typically less costly than the older defined-benefit pension plans that many companies had used. Companies are not required to contribute matching funds, and if they elect to do so, the amount of such funds is easily predictable in advance. Also, if the plans are outsourced to financial intermediaries, there is no administrative cost for the employer. Employees tend to like the plans, because they are able to save pre-tax dollars and often receive matching contributions from employers. Also, funds held in the plans are protected from creditors. However, unlike pensions, 401(k) plans produce no guaranteed benefit, since they may be invested in stocks and other securities that may lose some or all of their value. Nevertheless, 401(k) plans became a powerful vehicle to provide retirement income for participants. The stock market, meanwhile, was boosted tremendously by the increased availability of investment funds.
Bibliography
Gale, William G., John B. Shoven, and Mark J. Warshawsky, eds. The Evolving Pension System: Trends, Effects, and Proposals for Reform. Washington, D.C.: Brookings Institution Press, 2005. Includes discussion of various effects of pension plans and the impact of 401(k) plans on household savings and wealth.
Munnell, Alicia H., and Annika Sundén. Coming Up Short: The Challenge of 401(k) Plans. Washington, D.C.: Brookings Institution Press, 2004. Discusses the advantages and disadvantages of 401(k) plans. Includes an extensive bibliography.
U.S. Senate. The Role of Employer-Sponsored Retirement Plans in Increasing National Savings: Hearing Before the Special Committee on Aging, United States Senate, One Hundred Ninth Congress, First Session, April 12, 2005. Washington, D.C.: U.S. Government Accountability Office, 2005. Excellent overview of the impact that 401(k) plans have had on the level of national savings.