401k History & Background

The 401(k) plan is a type of employer-sponsored retirement plan named after a section of the U.S. Internal Revenue Code. A 401(k) plan allows a worker to save for retirement while deferring income taxes on the saved money and earnings until withdrawal. The employee elects to have a portion of his or her wage deferred directly into his 401(k) account. In participant-directed plans, the employee can select from a number of investment options, usually an assortment of mutual funds that emphasize stocks, bonds, money market investments. Many companies' 401(k) plans also offer the option to purchase the company's stock. The employee can generally re-allocate money among these investment choices at any time. In the less common trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan's assets will be invested.

All assets in 401(k) plans are tax deferred. Before the January 1, 2006 effective date of the designated Roth account provisions, all 401(k) contributions were on a pre-tax basis, and the contributions and growth on them are not taxed until the money is withdrawn. With the enactment of the Roth provisions, participants in 401(k) plans that have the proper amendments can allocate some or all of their contributions to a separate designated Roth account, commonly known as a Roth 401(k). Qualified distributions from a designated Roth account are tax free, while contributions to them are on an after-tax basis (i.e., income tax is paid or withheld on the income in the year contributed).

In 1978, Congress amended the Internal Revenue Code to add section 401(k). Work on developing the first plans began in 1979. Originally intended for executives, section 401(k) plans proved popular with workers at all levels because it had higher yearly contribution limits than the Individual Retirement Account (IRA); it usually came with a company match, and provided greater flexibility in some ways than the IRA, often providing loans and, if applicable, offered the employer's stock as an investment choice. Several major corporations amended existing defined contribution plans immediately following the publication of IRS proposed regulations in 1981.

A primary reason for the explosion of 401(k) plans is that such plans are cheaper for employers to maintain than a pension for every retired worker. With a 401(k) plan, instead of required pension contributions, the employer only has to pay plan administration and support costs if they elect not to match employee contributions or make profit sharing contributions. In addition, some or all of the plan administration costs can be passed on to plan participants. In years with strong profits employers can make matching or profit sharing contributions.