How 401(k) Plans Came To Be and How They’ve Evolved Over the Years
Employers often offer traditional 401(k) plans to their employees to help them save for retirement. Employees who participate in this type of plan have a portion of their paychecks contributed pre-tax toward the plan, which means they won’t pay taxes on the contribution amounts and investment earnings until they withdraw the money later in retirement. Some employers offer to match a portion of employee-contributed funds (also pre-tax) which can significantly boost the employee’s 401(k) balance.
Although 401(k) plans are popular and many employers offer them, they haven’t always been an option to build retirement savings. Find out how 401(k) plans came to be and how they’ve evolved over the years.
How Did Employees Save for Retirement Before 401(k) Plans?
Before 401(k) plans were an option, the old-fashioned, employer-funded pension plan (also known as a defined benefit plan) provided a fixed income post-retirement after working for a company for a number of years.
“The retirement landscape before the rise of the 401(k) was dominated by the defined benefit pension plan (DB plan),” said David Frederick, the director of client success and advice at First Bank. “With the DB plan, an employer agrees to pay an employee a certain percentage of his or her salary after that employee retires. DB plans were widespread, especially prevalent in large corporations and governments.”
Frederick continued, “Indeed, retirement planning in the middle of the 20th Century was defined by the three-legged stool, the idea that a person’s retirement would be held up equally by the three legs of Social Security, personal savings, and the DB pension. Employers would compete with each other as to which would offer the most generous pension benefits and employees would find themselves committing to very few employers (usually just one) for the majority of their careers to build up the best DB pension for retirement.”
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Why Was There a Need for 401(k) Plans?
“Defined benefit pensions plans started to show cracks by the end of the 1960s,” said Frederick. “A DB plan creates a long-term, defined liability for a sponsoring company. That is, the company is going to pay a set amount to a former employee for the rest of his or her life, even though that former employee no longer contributes to the financial welfare or growth of the employer. Moreover, pension funds had to continue to expand and grow over time to meet an employer’s expanding liability, but contributions to funds may stall when the employer faced a tough year, and a market downturn could hurt the pension fund’s investments. Employers realized that the DB pension system was creating an ever more unsustainable burden for them, and they began to look for another option.”
Frederick went on, “Meanwhile, employees had begun to lose their love of DB pensions as well. While a long-term employer with a secured pension may like the arrangement, younger employees realized that they were getting locked into a long-term relationship with one employer in pursuit of a pension. This gave the employer disproportionate leverage in the employment relationship to prevent employees from seeking better opportunities. Add to this mix the fact that the government had become increasingly worried about retirement funding in the late 1960s. The government discovered that DB pensions were generally reserved for highly compensated employees, not the rank and file, and that more and more lower-income workers were relying exclusively on Social Security for their retirement cash flow.”
“By the 1970s, the government believed there was a major need to reform the pension system to relieve some burden from DB sponsoring employers, free up the workforce to move around more, and allow more workers to access retirement savings. The result of these pressures was the passage of the Employee Retirement Income Security Act of 1974 (ERISA), which set out the modern paradigm of retirement savings, generally including the rise of 401(k) plans.”
Why Is It Called a 401(k) Plan?
The 401(k) plan program is named after the relevant section of the Internal Revenue Code, which was a provision of the Revenue Act of 1978.
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“SubChapter D of the IRC runs from Section 401 to 436 and lays out the rules an employer must follow when setting up a retirement plan,” said Frederick. “Section 401 is the primary section of this SubChapter and lists the most important rules that must apply to all retirement plans. Section 401 is extremely long and quite complex. Running at more than 60 pages, Section 401 is a dizzying blur of tax rules, a labyrinthine demonstration of just how blindingly complex tax laws can be. But in the middle of this desert of rules, numbers, tests, procedures, takebacks, disallowances, references, amendments, workarounds, timing instructions and various other minutiae is an oasis: Section 401(k).”
“Section 401(k) lays out a very simple, straight-forward retirement plan structure that will always pass the requirements in Section 401 and the rest of SubChapter D. That is, Section 401(k) is a hidden key that allows employers to unlock the entire code of retirement planning, skip the rules, skip the lawyers and establish a plan the government will preemptively respect and uphold.”
How Did the 401(k) Plan Become so Popular?
After the tax code went into effect, several large companies began adopting and developing 401(k) plans. By 1990, the number of active participants had risen to more than 19.5 million. The number of companies shifting towards 401(k) plans increased in 1992, when legislation was introduced limiting fiduciary liability, and then again in 1996 with the introduction of SIMPLE plans aimed at small businesses.
“401(k) plans became popular because they were shortcuts to creating a retirement plan for the employees that would save employers tremendous time, cost and headaches,” said Frederick.
How Have 401(k) Plans Evolved Since Their Inception?
401(k) plans have evolved in many different ways since their inception. Here are some of them.
Automatic Enrollment Rule
In 1998, the IRS issued a rule allowing employers to automatically enroll newly eligible employees into 401(k)s, also known as “negative elections.” In 2000, the IRS provided additional guidance on negative elections by allowing automatic enrollment in 401(k) plans for already-eligible employees who are deferring at a rate that is less than the automatic enrollment rate.
The Economic Growth and Tax Relief Reconciliation Act
“In the early 2000s, 401(k)s underwent several changes after The Economic Growth and Tax Relief Reconciliation Act,” said Riley Adams, CPA and founder of Young & the Invested. “For example, it allowed participants that were over the age of 50 to contribute a larger percentage of their salary to make up for the lack of contribution earlier in life.” It also increased elective annual deferral limits. In 2006, the Pension Protection Act made these changes permanent.
The EGTRRA also allowed for a new retirement savings plan to be established: the Roth 401(k), which allows employees to make after-tax contributions, which differs from the traditional 401(k).
“The biggest change since the rise of the 401(k) is likely the rise in popularity of Roth 401(k) plans …” said Frederick. “The 401(k) plan has always been predicated on a simple deal: an employee sets aside money for retirement and takes a deduction, the employer may match some of the money set aside in a non-taxable contribution for the employee, the money grows tax-free over time, and the employee takes taxable distributions in retirement.”
“In other words, the traditional 401(k) gives a tax advantage now but imposes a tax later. A strange call came up in some circles in the 1990s to reverse the deal: tax the employee now, let the funds grow tax-free, and the employee can take out tax-free funds in retirement. After running some tests that showed that this arrangement would result in essentially the same tax collections over time, Congress assented to this arrangement and allowed for Roth IRAs and Roth 401(k)s.”
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