401(K) PLANS

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. By the mid-1990s, 401(k) plans ranked among the most popular and fastest-growing types of retirement plans in America. In fact, according to Stephen Blakely in Nation's Business, funds held in 401(k) plans increased from $190 billion to $925 billion between 1987 and 1997.


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 deferred-bonus 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 establish 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 which 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 retain qualified employees who may previously have opted for the security of a large company and its pension plan.


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.

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) reduced maximum contribution limits that had been set by ERISA, introduced the "top heavy" concept, and revised the rules for federal income tax withholding on plan distributions. Most plans allowed employees to defer 1 percent to 10 percent of current compensation, but such internal limitations have been bound by compensation and contribution ceilings enumerated in TEFRA and sub-sequent legislation. In 1996, the amount an employee could defer annually under such programs was set at $9,500. In addition, the sum of employer and employee contributions was limited to 25 percent of annual compensation, or $30,000 per individual. The employer was further limited to an annual contribution of 15 percent of 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 $150,000 per year.

These limits have made senior executives and other highly paid employees the big losers under 401(k) plans. Mandatory "top heavy" tests prevent 401(k) programs from favoring highly compensated employees and restrict 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 others. 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. This test adds a second level of limitation on the amount that highly paid employees can defer, often reducing it from legally established limits. 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.

The Deficit Reduction Act of 1984 (DEFRA) continued the government's revenue-raising—and often 401(k)-limiting—provisions. The Retirement Equity Act (REACT or REA) of that same year helped protect spouses of plan participants by requiring that qualified plans provide numerous survivor benefits. The Tax Reform Act of 1986 (TRA 86) incorporated some of the most extensive, revenue-raising changes in 401(k) criteria since ERISA by imposing new coverage tests and accelerating vesting requirements. Although much of this legislation was intended to benefit employees, it has also been cited as the principal cause of the voluntary termination of thousands of pension plans—a total of 32,659 between July 1987 and September 1988. These terminations eliminated future pension benefits for hundreds of thousands of workers.

During the 1980s, many plan sponsors offered employees only two investment options for their 401(k) accounts: an insurance company's guaranteed income contract (GIC) and a profit-sharing plan. Insurance companies often had full-service capabilities in place and the GICs, with their high interest rates, garnered the lion's share of plan sponsors and participants. Statistics from the Employee Benefit Research Institute and the U.S. Department of Labor showed that about 40 percent of the assets in 401(k) plans were invested in GICs, which placed the burden of performance on employers and their fiduciary agents. But a rash of insurance company failures late in the decade prompted many portfolio managers to increase the number of investment alternatives.

A new provision, ERISA rule 404(c), that went into effect January 1, 1994, stipulated several changes in the way employers administered their programs. First, plans were required to offer at least three distinctly different investment options that spanned the entire investment spectrum, in addition to the employer's stock. Qualified plans were also compelled to educate participants by providing adequate information about each investment option, thereby enabling employees to make informed choices among them. Finally, employers and their 401(k) administrators were obliged to make more frequent performance reports and allow more frequent changes in investments. These changes have shifted the responsibility for choosing investments from employer to employee, thereby limiting the potential liability of employers for investment results. Although 404(c) is not mandatory, industry observers predicted that many plan sponsors would comply with the new provisions in the interest of happier, more financially secure employees. Compliance was also expected to help employers avoid liability for losses employees suffered in their 401(k) accounts due to fluctuations in the value of their investments.

It was anticipated that the enactment of provision 404(c) would trigger an investment shift among 401(k)s from GICs and employer stocks to mutual funds. Mutual funds were seen as an easy way for employers to comply with 404(c) because of the benefits and services they afforded, including access to top professional money managers, instant diversification, portfolios managed according to specified investment objectives and policies, liquidity, flexibility, and ease and economy of administration.


The shift from defined-benefit plans to defined-contribution plans such as 401(k)s has had both positive and negative ramifications for both employees and employers. On the downside, employees have been compelled to shoulder more of the financial burden for their retirement, and employers have had a larger responsibility to report their application of pension funds. But most observers have applauded the movement. 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 receive favorable tax treatment. In addition, 401(k)s offer loan provisions that many other types of plans lack.

On the negative side, employees may find that deferring taxes through a 401(k) was a bad idea if tax rates increase. In addition, many investors may become frustrated by their inability to utilize their savings before retirement without paying a hefty penalty. Finally, participants are limited as to the amount of annual savings allowed under a 401(k) plan, and their contributions automatically stop if they become disabled and are forced to quit working.

But 401(k) plans offer many advantages for employers. For example, employers have been able to share or even eliminate their pension contributions. And if employers do choose to contribute, they too get 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.). Beginning in the mid-1990s, these types of institutions began competing to serve the small business sector, since only 25 percent of small employers (with between 50 and 100 employees) sponsored 401(k) plans, compared to 80 percent of large employers (with more than 1,000 employees). By 2000, a number of online brokers began serving as 401(k) administrators for small businesses. By taking advantage of automation, these brokers enabled entrepreneurs to offer their employees sophisticated plans at a reasonable cost.

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. In addition, all the information reported on Form 5500 is open to public inspection. But, for many business owners, the advantages of 401(k) plans outweigh the disadvantages. It has become the most popular type of plan for businesses with more than 25 employees.


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SEE ALSO: Retirement Planning

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