2018 happens to be a big year for the 401(k) plan, as it marks its 40th birthday! A lot has changed over the past four decades, not least of all the 401(k) plan, which has been revised and morphed to better serve its participants. Let’s take a look into the past to discover how the 401(k) plan came to be and why it’s the most widely used and well-known retirement savings plan in the United States.
An Overlooked Tax Provision Revolutionizes Retirement Saving
When Congress passed the Revenue Act of 1978, it included provision Section 401(k) — which didn’t get much attention at the time. The provision allowed employees to avoid taxation on a portion of their income if they elected to receive it as deferred income.1
For two years, the provision sat unnoticed — until Ted Benna came along. Now known as the “father of the 401(k),” Benna was a benefits consultant for Johnson Companies. When he saw the potential benefit of the provision, he urged his company to implement it into their current employee savings plan.2
By 1984, the new 401(k) approach to retirement saving really took off, with more than 7.5 million plan participants and $92 billion in assets.3 By 1991, the number of participants had reached 48 million, and by 1996, the combined assets of all 401(k) plans surpassed the $1 trillion mark.4
The plan saw major modifications in 2001 when Congress passed the Economic Growth and Tax Relief Reconciliation Act, which allowed participants age 50 and older to make “catch-up contributions.” The Act also allowed companies to offer Roth 401(k) accounts, which make post-tax contributions while providing tax-free growth and distributions — unlike the traditional 401(k).5 Today, 401(k) plans hold more than $5.3 trillion in assets.6
The 401(k) Becomes Our Primary Retirements Savings Vehicle
With such a large volume of participants, and remarkable success, it might come as a surprise that the plan was created unintentionally and not by design. In the late 1980s, the federal government twice tried to invalidate 401(k) plans. There was a large concern that with the plan’s tax-deferral feature, tax receipts would fall too fast as people funded their plans. In fact, it’s estimated that plans cost the government more than $115 billion a year in tax revenues. However, despite the large tax revenue hit, the government encourages the use of 401(k) plans because they reduce government spending on welfare programs for the elderly, as Americans are better funding their own retirement.7
In its earliest days, the 401(k) plan was much more basic than it is now. Its original intended purpose was to serve as a supplemental retirement account to pension plans, with most of the investments being held in company stock.
It did not take long for employers to see the advantages of forgoing the use of traditional pensions and implementing 401(k) plans to replace them. With 401(k) plans, employers saw a significant decrease in the cost of providing retirement benefits to their employees, allowing small-sized firms to stay competitive by offering similar benefits packages to employees as those found in larger companies. Plus, the burden of saving shifted from the employer to the employee.
While this shift caused added responsibility for employees, in return they benefited from the tax advantage and flexibility a pension did not provide. Traditional pension plan payouts typically were based on an employee’s salary and years of experience, but 401(k) plans gave all employees the freedom to choose how much to save, with the opportunity to enroll soon after they began to work for the company. The plan’s design also allowed employees to take their contributed money with them if they changed jobs.8
The past 40 years have been pretty impressive for an almost unnoticed provision in the tax code. As most Americans’ primary tool for saving for retirement, the 401(k) has drastically changed the way we save. Three cheers for 40 years!