The 869-word paragraph k, added to Section 401 of the Internal Revenue Code in 1978, is a rock star. Now the most widely used and best-known retirement savings plan in the United States, the 401(k) was the brainchild of benefits consultant Ted Benna. In 1979, Benna noticed that rules established in the Revenue Act of 1978 made it possible for employers to set up simple, tax-advantaged savings accounts for their employees1.

Benna, a benefits consultant, was working with a bank, hoping to find a better way to retain employees without handing out large, taxable annual bonuses. The bank wanted a profit-sharing plan that would keep it competitive with other banks in compensation and provide a tax break on contributions. In 1979, Benna knew that the IRS's 401(k) provision, passed in 1978, would take effect in 1980. Although many accountants knew about the provision, they paid little attention because it was intended for a different purpose. But Benna saw how employees could contribute all or part of their bonuses to a 401(k) and get immediate tax relief. To sweeten the deal, Benna added a matching contribution option for the bank.

Benna's bank client rejected the idea, afraid to try something new and concerned that the Internal Revenue Service would reverse it. So Benna created a 401(k) plan for his own firm, The Johnson Company. By 1981, the IRS had proposed formal rules for 401(k) plans.[2]

The following year, several large companies began offering new 401(k) plans to employees. Participants in 401(k) plans could then use deferred income to invest without paying taxes on earnings. These new accounts quickly became popular. In 1983, 7.1 million employees participated in a 401(k) plan, a number that rose to 38.9 million in 1993.[3] As of 2019, 401(k) plans covered approximately 80 million people and held $5.7 trillion in assets.[4]

In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act, allowing catch-up contributions for participants age 50 or older. The law also allowed companies to offer Roth 401(k) accounts, which require after-tax contributions but provide tax-free growth and distributions.[5]

Purpose and Uses

Modern 401(k) plans were not deliberately designed by the U.S. government or the Internal Revenue Service. In fact, the U.S. Treasury Department under Ronald Reagan proposed eliminating the 401(k) in 1984.[7] The concern was that tax revenue would fall too quickly as more workers funded their retirement plans.

Employees receive two significant benefits from 401(k) plans and other tax-exempt retirement accounts: first, the obvious tax benefit.[8] Second, employees have a way to protect retirement savings from the loss of real purchasing power caused by inflation. On the downside, 401(k) plans are riskier for employees than defined benefit plans, which are guaranteed by the federal government.[9]

There are also obvious benefits for employers. For example, the cost of offering retirement benefits has declined significantly. Small businesses particularly benefit from the new defined contribution plans. These plans allow them to offer employees benefits packages similar to those at larger companies, leveling the playing field.[9]

The federal government encourages the use of 401(k) and other retirement plans. Although tax revenue falls as more people participate, a population that funds its own retirement ultimately reduces government spending on welfare programs for older adults.

References

1. Benna 401k. " A Brief History of 401K ". http://benna401k.com/401k-history.html
2. Federal Register. " Federal Register Vol. 46, No. 217 ", pages 55544–55550
   (https://tile.loc.gov/storage-services/service/ll/fedreg/fr046/fr046217/fr046217.pdf).
3. Federal Reserve Bank of St. Louis. " Not Your Father's Pension Plan: The Rise of 401(k) and Other Defined Contribution Plans ", page 23.
4. U.S. Department of Labor. " Private Pension Plan Bulletin ", pages 2–3.
5. U.S. Congress. " H.R.1836 - Economic Growth and Tax Relief Reconciliation Act of 2001 ".
6. U.S. Department of the Treasury. " Tax Reform for Fairness, Simplicity, and Economic Growth ", page 116.
7. Internal Revenue Service. " 401(k) Plans ".
8. Pension Benefit Guaranty Corporation. " How PBGC Operates ".
9. U.S. Department of Labor. " Choosing a Retirement Solution for Your Small Business ".