Cameron Miranda
The 401(k) plan is an employer-sponsored, defined-contribution, personal pension (savings) account, as defined in subsection 401(k) of the U.S. Internal Revenue Code. The modern 401(k) originated in 1978 with a provision in the Revenue Act of 1978, which allowed employees to choose to receive a portion of their income as deferred compensation and created tax structures around it. The first 401(k) plan was established by Ted Benna at his employer, the Johnson Companies, where he was a benefits consultant. Benna noticed that the rules established in the Revenue Act of 1978 made it possible for employers to establish simple, tax-advantaged savings accounts for their employees.
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What You'll Learn
The Revenue Act of 1978
Provisions of the Revenue Act of 1978
The Act included a range of provisions aimed at reducing income taxes and simplifying tax processes for individuals and businesses:
- It amended the Internal Revenue Code to lower income taxes for the aforementioned entities for taxable years starting after December 31, 1978.
- The Act increased the zero-bracket amount for certain surviving spouses and married individuals filing joint returns to $3,400, $2,300 for unmarried individuals, and $1,700 for married individuals filing separately.
- It adjusted withholding amounts to reflect the increased zero-bracket amounts and raised the personal exemption from $750 to $1,000.
- The Act made the earned income credit permanent and increased its allowable amount. It also eliminated the requirement for an individual to maintain a household in the US to be eligible for this credit.
- Employers were required to make advance payments of the earned income credit to employees who qualified for it during the current year.
- The Revenue Act of 1978 provided exclusions from gross income for payments made to landowners under various conservation and environmental protection programs, such as the Water Bank Act and the Agricultural Credit Act of 1978.
- It introduced the concept of a GSOC (Group Service Organization Corporation), allowing them to elect an exemption from income taxes and defining their tax obligations.
- The Act also made technical amendments to income tax and administrative provisions in the Internal Revenue Code related to retirement income credit, net operating losses, construction period interest, and more.
Impact on 401(k) Plans
- The Act included a provision in Section 401 that allowed employees to choose to receive a portion of their income as deferred compensation, creating tax structures around it.
- Ted Benna, a businessman, interpreted this section aggressively and established the first 401(k) savings plan in the US for his consulting company. He advocated for regulations and helped steer the adoption of 401(k) as a retirement tool.
- The Revenue Act of 1978 created the foundation for 401(k) savings plans, enabling employees to steer a portion of their income into an account where it could grow through investments, thus planning for their retirement.
- It's worth noting that while the Act laid the groundwork, subsequent regulations, and interpretations were necessary to fully establish the 401(k) system.
Other Notable Impacts
- It provided relief from federal employment tax obligations for businesses that met certain statutory requirements under Section 530.
- The Act also encouraged the adoption of flexible spending accounts for medical expenses and clarified the independent contractor classification, impacting how companies pay employment taxes.
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Ted Benna's interpretation
Ted Benna is often referred to as the "Father of the 401(k)". He was among the first to establish a 401(k) plan, creating it at his own employer, the Johnson Companies. Benna was trying to reduce the taxes due on a deferred-compensation bonus plan for bank executives, at a time when the top marginal income tax rate was 70%.
Benna's self-described "aggressive" interpretation of the eponymous 401(k) section within the Act led him to create the first-ever 401(k) savings plan in the US for his consulting company. He interpreted the section to mean that employees could put money in pre-tax, and that employers could match employee contributions. Benna's interpretation enabled profit-sharing plans to adopt CODAs.
Through business connections, Benna was introduced to Treasury officials and provided recommendations on how 401(k) should be regulated. He helped steer the success and adoption of the nascent retirement tool.
Benna has since expressed concerns about the evolution of the 401(k) since it became mainstream in the 1980s. He has noted that the original intention was for employers to cover the fees of these plans, but that this has changed, with employers pushing costs onto workers. He has also pointed to the complexity of the investment structure and high fees as issues.
Benna has written several books on the 401(k) and continues to provide consulting support to small employers. He advocates for laws that would require employers to auto-enroll their workers in 401(k) plans.
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ERISA and SECURE Acts
The 401(k) is a subsection of the U.S. Internal Revenue Code, and while the term has become synonymous with analogous pension schemes internationally, it was created by U.S. law.
The modern 401(k) was created by a provision in the Revenue Act of 1978, which allowed employees to receive a portion of their income as deferred compensation, with associated tax structures. However, the two key pieces of legislation that govern 401(k) plans are the Employee Retirement Income Security Act (ERISA) of 1974 and the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019.
ERISA was introduced to set minimum standards for voluntarily established retirement and health plans in private industry, to protect individuals enrolled in these plans. It was a response to growing concerns over the mismanagement of pension plans. ERISA requires administrators of 401(k) plans to regularly inform participants about their features and funding, and it sets minimum standards for participation, vesting, benefit accrual, and funding. It also grants retirement plan participants the right to sue for benefits and breaches of fiduciary duty.
The SECURE Act of 2019 was the most extensive overhaul of 401(k) provisions since their inception. It provided a maximum tax credit of $500 per year to employers who created a 401(k) or SIMPLE IRA plan with automatic enrolment. It also pushed back the age at which retirement plan participants need to take required minimum distributions (from 72 to 73-75, depending on the year of birth), and permitted penalty-free withdrawals of $5,000 from 401(k) accounts to defray the costs of having or adopting a child.
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Economic Growth and Tax Relief Reconciliation Act
The Economic Growth and Tax Relief Reconciliation Act of 2001 was a significant piece of tax legislation passed by the 107th United States Congress and signed by President George W. Bush. It is also referred to as one of the "'Bush tax cuts'" and abbreviated as EGTRRA. The act was passed by Congress in May 2001 and signed into law by Bush in June 2001.
The EGTRRA lowered federal income tax rates, including reducing the top tax rate from 39.6% to 35%. It amended the Internal Revenue Code to establish a 10% individual tax bracket for various filing statuses, with taxable income thresholds outlined for each category. Additionally, it phased in increases in the standard deduction for married couples filing jointly, aiming to provide tax relief from the "marriage penalty."
The act also included revisions to the tax treatment of section 457 plan benefits upon divorce, applying taxation rules for qualified plan distributions and directing a reduction in the safe harbor relief period for hardship financial needs.
The Economic Growth and Tax Relief Reconciliation Act paved the way for changes to 401(k) plans, such as allowing catch-up contributions for employees aged 50 and older and introducing the Roth 401(k). The Roth 401(k) is similar to the traditional 401(k) in being employer-sponsored but differs in how contributions and withdrawals impact income tax.
It is worth noting that the 401(k) plan itself was created earlier, with its origins traced back to the Revenue Act of 1978, which allowed employees to choose to receive a portion of their income as deferred compensation, creating tax structures around it.
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Pension Protection Act
The Pension Protection Act (PPA) was enacted into law in 2006 by then-President George W. Bush, who described it as "the most sweeping reform of America's pension laws in over 30 years." The Act introduced numerous changes to the tax law provisions affecting tax-exempt organisations.
The PPA expanded on the protections provided by the Employee Retirement Income Security Act of 1974 (ERISA), which requires plans to keep their participants informed and makes it harder for bad actors to take advantage of people saving for retirement or earning a pension. The PPA strengthened protections for workers who are owed pension benefits. It also created new laws for pension and retirement plans and made permanent some temporary laws from 2001.
The PPA made it easier for employers to automatically enrol employees in workplace retirement plans, and it increased how quickly employer contributions to employees' defined-contribution plans vest. Employees also gained the right to diversify out of employer stock in their retirement plans.
The Pension Protection Act of 2006 also included some unrelated provisions, such as those related to leather basketballs, rubber basketballs, and volleyballs.
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Frequently asked questions
The modern 401(k) was created by a provision in The Revenue Act of 1978, which was signed by President Jimmy Carter.
A 401(k) is a retirement savings plan that allows employees to contribute a portion of their income to an account where the money can grow through investments.
Employees can choose to contribute a portion of their income to a 401(k) plan, which is typically sponsored by their employer. The contributions are often made through salary deductions, and the money in the account grows through investments over time.
Ted Benna, a benefits consultant at the Johnson Companies, is often credited with creating the first 401(k) plan in 1979. He interpreted the Revenue Act of 1978 as an opportunity for employers to create tax-advantaged savings accounts for their employees.
