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.
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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 deferredbonus 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.
Passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) changed the taxation landscape in the Untied States. With respect to 401(k) plans, several changes were made. For the most part these changes helped to increase the amount that individuals and companies are able to contribute to 401(k) plans on a tax-deferred basis.
As of 2006, the amount an employee could defer annually under such programs was set at $15,000. In addition, the sum of employer and employee contributions to one individual’s account was set at either 100 percent of annual compensation or $40,000, whichever was higher. The employer was further limited to an annual contribution of 15 percent of total payroll, including both employee deferrals and employer matching and profit-sharing contributions. Finally, the amount of compensation that could be considered in determining an employee’s deferral was limited to $200,000 per year.
The contribution limits and percentage rates used to calculate plan-wide limits change from year to year and make the administering of these plans a very complex task.
These limits tend to restrict senior executives and other highly paid employees more than the majority of employees. Mandatory “top heavy” tests prevent 401(k) programs from favoring highly compensated employees by restricting the amount that a company’s top earners can contribute to 401(k) plans. Known as “nondiscrimination tests” in the benefits industry, top heavy rules separate employers and employees into two groups: those who are highly compensated and all the rest. The amount that the highly paid employees may defer is based upon what the lower-paid employees deferred during the year.
If the average lower-paid employee only contributed 2 percent of his or her compensation to the corporate 401(k), for example, highly paid employees may only divert 4 percent of their pay. Benefits and tax specialists have, of course, devised strategies to circumvent these restrictions, such as 401(k) wrap-arounds, “rabbi trust arrangements,” and other “non-qualified” plans that consciously and legally operate outside the bounds of “qualified” 401(k)s. Such plans are costly to administer and run and are not often seen in small company settings.
Advantages And Disadvantages Of 401(K) Plans
The shift from defined-benefit plans to defined-contribution plans such as 401(k)s has had both positive and negative ramifications. On the downside for employees is their need to shoulder more of the financial burden for their retirement. Compared to defined-benefit plans, definedcontribution plans are risky. Instead of a federally guaranteed pension pay-out upon retirement, 401(k) plan holders make their own investments which offer the hope of great gains but also contain the potential for great losses. The story of Enron and the stock market declines of the early 2000s both showed what could happen to investments in a 401(k) plan. Nonetheless, most observers have applauded the movement towards greater reliance on 401(k) plans. Employees have gained greater control over their retirement assets. The plans provide immediate tax advantages as the contributions are not subject to federal income taxes nor to most state and local taxes. They also provide long-term tax advantages, as earnings accumulate tax-free until withdrawal at retirement, when withdrawals can presumably receive favorable tax treatment. In addition, 401(k)s offer loan provisions that many other pension plans lack.
For employers, 401(k) plans offer many advantages.
For example, employers have been able to share or entirely eliminate their pension contributions. And if employers do choose to contribute, the employer too gets a tax deduction.
401(k)s have evolved into a valuable perk to attract and retain qualified employees. Employers can even link contributions to a profit-sharing arrangement to increase employee incentive toward higher productivity and commitment to the company. By enabling employees to become active participants in saving and investing for their retirement, 401(k) plans can raise the level of perceived benefits provided by the employer.
Small business owners can set up a 401(k) plan by filling out the necessary forms at any financial institution (a bank, mutual fund, insurance company, brokerage firm, etc.). There are several types of 401(k) plans that may be used, one of which is the SIMPLE 401(k) plan.
The IRS Web site explains that this sort of plan was especially created so that small businesses could have an effective cost-efficient way to offer retirement benefits to their employees. A SIMPLE 401(k) plan is not subject to the annual nondiscrimination tests that apply to the traditional plans. The employer is required to make employer contributions that are fully vested. This type of 401(k) plan is available to employers with 100 or fewer employees who received at least $5,000 in compensation from the employer for the preceding calendar year. In addition, employees that are covered by a SIMPLE 401(k) plan may not receive any contributions or benefit accruals under any other plans of the employer.
The fees involved in establishing and administering a 401(k) plan can be relatively high, since sponsors of this type of plan are required to file Form 5500 annually to disclose plan activities to the IRS. The preparation and filing of this complicated document can increase the administrative costs associated with a plan, as the business owner may require help from a tax advisor or plan administration professional. Fortunately, for companies with fewer than 100 employees, a SIMPLE 401(k) plan is an option and one that entails fewer fees and administrative costs.