The Evolution Of Retirement Plans: 401(K) Law History

The 401(k) plan, an employer-sponsored, defined-contribution, personal pension (savings) account, was made possible by the Revenue Act of 1978, which was passed on November 6, 1978. The law included a provision – Section 401(k) – that allowed employees to defer compensation from bonuses or stock options without paying taxes. The law came into effect on January 1, 1980. Ted Benna, a benefits consultant, is widely regarded as the father of the 401(k), as he was among the first to establish a 401(k) plan at his own company, the Johnson Companies.

The Revenue Act of 1978

Ted Benna, a benefits consultant at the Johnson Companies, saw the Revenue Act of 1978 as an opportunity for employers to create tax-advantaged savings accounts for their employees. Benna designed the 401(k) plan for a bank client seeking to give employees additional retirement benefits. However, the bank rejected the idea, so Benna offered the first 401(k) plan to his own employees at The Johnson Companies.

By 1981, the IRS had proposed formal rules for 401(k) plans, allowing employees to contribute through salary deductions. This jump-started the widespread roll-out of 401(k) plans in the early 1980s. By 1983, nearly half of all large firms offered or considered offering a 401(k) plan.

Ted Benna's role

Ted Benna is often referred to as the "father of the 401(k)". He is a benefits consultant and was working at the Johnson Companies (now known as Johnson Kendall & Johnson) when he pioneered the 401(k) plan.

In 1979, 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. He designed the 401(k) plan for a bank client seeking to give employees additional retirement benefits. However, the bank rejected the idea as it had never been done before. So, Benna offered the plan to his own employees at The Johnson Companies.

Benna's interpretation of the Revenue Act allowed employees to save pre-tax salary in a retirement account while also receiving a matching contribution from their employers. He told Forbes Advisor:

> "Neither one of those moves were included in legislation, which was only about a page and a half long. There was nothing saying you couldn’t do it, and nothing saying you could."

In the years following Benna's idea, the IRS and Treasury department essentially sanctioned his interpretation and the 401(k) took off. In 1981, the IRS issued rules that allowed employees to contribute to their 401(k) plans through salary deductions, which jump-started the widespread roll-out of 401(k) plans in the early 1980s. By 1983, nearly half of all large firms offered, or considered offering, a 401(k) plan.

The first 401(k) plan

Benna initially designed the plan for a bank client seeking to provide additional retirement benefits for its employees. However, the bank rejected the idea, so Benna offered the plan to his own employees at the Johnson Companies instead.

Under the plan, employees could contribute 25% of their salaries, up to $30,000 per year, to their employer's 401(k) plan. This allowed employees to take advantage of tax-free compensation deferrals from bonuses or stock options.

In 1981, the IRS issued rules allowing employees to contribute to their 401(k) plans through salary deductions, which led to the widespread roll-out of 401(k) plans in the early 1980s. By 1983, nearly half of all large firms offered, or considered offering, a 401(k) plan.

IRS rules in 1981

In 1981, the IRS issued rules that allowed employees to contribute to their 401(k) plans through salary deductions, which jump-started the widespread roll-out of 401(k) plans in the early 1980s. This was a significant development, as it made it easier for employees to save for retirement and take advantage of the tax benefits offered by 401(k) plans.

The IRS rules in 1981 were a result of changes to the tax code made by Congress in 1978 with the Revenue Act. This Act included a provision, Section 401(k), that allowed employees to defer taxation on parts of their income if they elected to receive it as deferred compensation rather than direct pay.

Ted Benna, a benefits consultant, noticed that these new rules created an opportunity for employers to establish simple, tax-advantaged savings accounts for their employees. He designed the first 401(k) plan for his own company, the Johnson Companies, and by 1981, the IRS had proposed formal rules for 401(k) plans.

The IRS rules in 1981 allowed employees to contribute to their 401(k) plans directly from their salaries, making it a convenient and efficient way to save for retirement. This also provided employees with tax benefits, as the deferred wages were not subject to federal income tax withholding at the time of deferral and were not reported as taxable income.

The widespread roll-out of 401(k) plans in the early 1980s was a significant shift in retirement savings for Americans. It provided a new option for employees to save for their future and took pressure off employers, who had previously relied on pension plans, which could be more costly and unpredictable to fund.

By 1983, nearly half of all large firms offered or considered offering a 401(k) plan, and the number of participants in 401(k) plans grew rapidly in the following years. Today, 401(k) plans have become the dominant source of retirement savings for most Americans, holding over $4.8 trillion in assets.

401(k) plans today

The 401(k) plan has become the dominant source of retirement savings for most Americans. As of 2019, 401(k) plans covered an estimated 80 million people and held $5.7 trillion in assets. In 2023, Americans saved an average of 7.1% of their salaries in their 401(k)s, with the employee contribution limit for 2024 being $30,500 (including "catch-up" contributions) for those 50 and older, and $23,000 for those under 50.

There are two main types of 401(k)s: traditional and Roth. With a traditional 401(k), employee contributions are pretax, meaning they reduce taxable income, but withdrawals in retirement are taxed. Employee contributions to Roth 401(k)s, on the other hand, are made with after-tax income. There is no tax deduction in the contribution year, but withdrawals—qualified distributions—are tax-free.

The 401(k) plan was designed to encourage Americans to save for retirement, with tax savings as one of its key benefits. If an employer offers both types of 401(k) plans, employees can split their contributions, putting some money into a traditional 401(k) and some into a Roth 401(k).

While the traditional 401(k) has been around since the early 1980s, the Roth 401(k) was introduced more recently, in 2006. With a traditional 401(k), employee contributions are deducted from gross income, reducing taxable income for that tax year. Taxes are then due on the money contributed or the investment earnings upon withdrawal.

On the other hand, with a Roth 401(k), contributions are deducted from after-tax income, so there is no tax deduction in the year of the contribution. However, upon withdrawal during retirement, no additional taxes need to be paid on the contribution or the investment earnings.

It is generally recommended that employees contribute the maximum allowable amount to their 401(k) plans. Additionally, if an employer offers matching contributions, it is crucial to take advantage of this benefit to maximize retirement savings.

While 401(k) plans have experienced tremendous growth and are an important component of America's retirement savings system, they have also faced criticism. One concern is that they shift the responsibility and risk of saving for retirement from employers to employees, and may not provide sufficient funds for retirement, especially when compared to traditional pension plans. Additionally, 401(k) plans may come with fees and have restrictions on early withdrawals, with penalties for withdrawing funds before the age of 59½.

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