401(k) plans have had a long and evolving history, offering advantages to employers and employees alike.
Over the past three decades, we have seen a fundamental shift in the way the American population is preparing for retirement. Traditional pension plans based on salary and years of service are withering away, while self-directed defined contribution plans such as the 401(k) are showing rapid growth. As many know, the 401(k) plan is a cash-deferred arrangement in which an employee can elect to have their compensation contributed to a qualified retirement plan in the form of a pre-tax deferral. Prior to 1974, there were deferred compensation arrangements, known as CODAs, which allowed for some compensation to be deferred. Those plans were the predecessors of the 401(k) plans of today.
ERISA: The Beginning
The Employee Retirement Income Security Act (ERISA) was signed into law by President Gerald Ford on Labor Day of 1974. ERISA established minimum standards for pension plans in the private sector and now dictates the rules regarding federal income tax effects of transactions associated with employee benefit plans. ERISA was enacted to protect the interests of participants and their beneficiaries by requiring disclosures of financial and other information concerning the plan and establishing the standards of conduct for plan fiduciaries. Enforcement is divided among the Department of Labor, the Internal Revenue Service and the Pension Benefit Guaranty Corporation.
The Revenue Act of 1978, created in response to ERISA, mandates studies of salary reduction plans and includes a provision that became Internal Revenue Code (IRC) Sec. 401(k). Under this code, employees aren’t taxed on the income they elect to defer into a 401(k) account and are only taxed on the income they receive as cash payment. The legislation was officially signed into law on January 1, 1980, with additional regulations issued in November, 1981. By the end of 1984, 17,303 plans featuring 401(k)s were available, and the number of participants in these plans was well over 7.5 million, with total assets reaching $91.75 billion.
Retirement security has historically been referred to as a “threelegged stool,” consisting of Social Security, private pensions (defined benefit plans) and personal savings. The private pensions “leg” is being replaced by the 401(k) defined contribution plan. As a result, the primary responsibility of preparing for retirement has been moved from the employer’s retirement plan sponsor to each individual employee.
As we move forward with the number of 401(k) defined contribution plans increasing, it is important to point out the advantages this change offers to both the employee and employer. Some notable advantages for the employee:
• The opportunity for tax-deferred earnings. Your taxable income decreases by the amount of compensation you defer. Income tax payment is postponed until the money is withdrawn at retirement.
• An opportunity to invest personally in your future. Nearly all 401(k) plans offer a variety of investment vehicle choices. Some standard investment choices provide mutual funds, money market funds or even company stock. Each type of investment can also offer varying degrees of risk and reward depending on your length of time to retirement or your own financial security preference.
• The plan may allow for a contribution match. If you defer compensation, the employer may offer a match up to a certain percentage. For example, your employer may contribute 50 cents of each deferred dollar you contribute to the plan.
• Portability gives you control. If you move from one employer to another, your 401(k) can move right along with you and continue to grow your retirement fund with a new qualified plan via rollover.
Notable employer advantages:
• Enticing benefits for employees. The employer can promote the many benefits offered through their 401(k) plan to not only attract new employees, but to retain them as well. One of these perks usually includes an investment planner available to employees for assistance in setting up and maintaining their personal plans.
• Productive and satisfied workforce. Employees appreciate that their employer is providing a way for them to plan and save for their retirement. Contribution matches help an employer become actively involved in this process. In turn, productivity is improved due to increased employee morale and satisfaction.
• Tax deductible. Employers also receive tax deductions for the contributions that are made to the plan along with the applicable expenses. It is a win-win situation for both the employer and the employee.
Safe Harbor and the Roth
As 401(k) plans have become more prosperous over the last three decades, some important additions have been made. The Small Business Job Protection Act of 1996 was the first change. It provided design-based “safe harbor” methods for satisfying the non-discrimination tests applicable to plans. The safe harbor 401(k) plan allows maximum deferrals by both owners and highly compensated individuals because a minimum-required contribution is provided to all participants. The employer is required to either match employee contributions of 100 percent of the first three percent deferred, plus 50 percent of the next two percent deferred, or provide a non-elective contribution of three percent of the salary of each participant. The safe harbor contributions are always 100-percent vested.
Another important addition was the Roth 401(k). Beginning in 2006, 401(k) plans allowed participants to designate a portion of their elective deferral for aftertax Roth contributions. The Roth 401(k) combines some of the most valuable features of both 401(k) plans and the Roth IRA. In general, the difference between a Roth and a traditional 401(k) is that the Roth version is funded with after-tax dollars, which represent compensation on which taxes are paid in the current tax year, not at the time of withdrawal. This allows an individual to save for retirement and grow his or her investments without paying taxes on capital gains and dividends. Unlike the traditional 401(k), Roth contributions are not tax-deductible; however, withdrawals upon retirement aren’t subject to income taxes, assuming you have had the account for at least five years. A Roth 401(k) may be most advantageous to younger workers who are currently taxed in a lower bracket, but expect to be taxed in a higher bracket later in life.
A Long Way in Peace of Mind
As the economy rebounds, employer contributions, such as match and profit sharing, are being reinstated. Investment options have changed to focus more on target funds, which invest for you based on what year you plan to retire. The investments become more conservative the closer you come to retirement age. 401(k) plans have come a long way in a short amount of time, and they are much better designed and take less work to manage. Be sure to take advantage of any retirement planning services and benefits offered by your employer. It is definitely worth your time and effort and will go a long way in providing you peace of mind for your future.iBi