Why were 401(k) plans created?

As the most widely used and well-known retirement savings plan in the United States, 401(k) plans were dreamed up by benefits consultant Ted Benna. In 1979, Benna noticed that the rules established in the Revenue Act of 1978 allowed employers to establish simple, tax-advantaged savings accounts for their employees.

History of the 401(k)

The term “401(k)” refers to Section 401(k) of the Internal Revenue Code. The provision allows employees to avoid tax on a portion of their income if they elect to receive it as deferred compensation rather than direct compensation.

Benna designed the 401(k) plan for a banking client looking to provide his employees with additional retirement benefits. However, the bank rejected the idea because it had never been done before, so Benna offered the first 401(k) plan to his own employees at The Johnson Companies. In 1981, the IRS proposed formal rules for 401(k) plans.

The following year, several large companies began offering new 401(k) plans to employees. Participants in 401(k) plans could then use their deferred income to make investments without being taxed on the gains.

These new accounts quickly became popular. In 1983, 7.1 million employees participated in a 401(k) plan, a number that grew to 38.9 million in 1993.In 2019, 401(k) plans covered approximately 80 million people and held $5.7 trillion in assets.

In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Actwhich allowed catch-up contributions for participants aged 50 and over. The law also allowed companies to offer Roth 401(k) accounts, which require after-tax contributions but offer the benefit of tax-free growth and distribution.

Purpose and uses of the 401(k)

Modern 401(k) plans were not an intentional design of the US government or the Internal Revenue Service. Indeed, the US Treasury Department under Ronald Reagan proposed to scrap the 401(k) in 1984. The fear was that tax revenues would fall too quickly as more workers fund their pensions.

Employees receive two important benefits from 401(k) plans and other tax-exempt retirement accounts: First, there is the obvious tax advantage. Second, employees have a way to protect their retirement savings against the loss of real purchasing power due to inflation. In contrast, 401(k) plans are riskier for employees than defined benefit plans, which are guaranteed by the federal government.

There are also clear advantages for employers. For example, the costs of providing retirement benefits have dropped significantly. Small businesses particularly benefit from the new defined contribution schemes. The plan allows these companies to offer employees similar benefits to large corporations, leveling the playing field.

The federal government encourages the use of 401(k)s and other retirement plans. Even if tax revenues decline as more people participate, a self-funding population eventually reduces public spending on social assistance programs for the elderly.

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