401(k) plans
Definition Tax-deferred retirement savings
programs
Date Began November 10, 1981
The 401(k) plan was named for the section of the Internal
Revenue Code that governs it. It allows employees to defer
paying taxes on a portion of their income that they invest to-
ward retirement. The money in the resulting investment
portfolio—including accrued interest—is taxed only when
it is withdrawn.
The history of the 401(k) plan dates back to the Rev-
enue Act of 1978, which added section 401(k) to the
Internal Revenue Code. That law went into effect on
January 1, 1980. However, the birthday of the plan is
typically celebrated to coincide with the November
10, 1981, issuance by the Internal Revenue Service
(IRS) ofRegulations on the Plan, which explained the
401(k) system and how to take advantage of it. Un-
der the employer-sponsored 401(k) plans, employ-
ees could elect to have a portion of their salaries de-
ducted from their paychecks and deposited directly
into retirement investment accounts. Many compa-
nies had previously sponsored such savings plans,
but those plans typically involved the use of after-tax
dollars. The 401(k) law, by contrast, allowed employ-
ees to save for retirement using before-tax dollars. As
a result, funds would accumulate faster, because the
original contribution and subsequent earnings on
the plan were all tax-free until they were withdrawn
after retirement. Employees were motivated to save
more for retirement, and the stock market benefited
from the increased funds available for investment.
Operational Details of the Plans The new retire-
ment plans were viewed as a good deal for employ-
ees, so many large companies, such as Johnson &
Johnson, PepsiCo, and JC Penney, quickly imple-
mented 401(k) plans. For many companies, the im-
plementation date was January, 1982. Within two
years, about half of all large American companies
had 401(k) plans in place. At many companies,
the plans replaced traditional pension plans, which
provided guaranteed income upon retirement. To
sweeten the shift to this new and riskier type of retire-
ment plan, and to make the new plans more enticing
to employees, companies often agreed to match em-
ployees’ contributions. Initially, the law allowed each
employee to defer up to $45,475 of salary each year,
but that amount was reduced to $30,000 in 1983 and
remained at that level throughout the rest of the de-
cade. By 1984, the Internal Revenue Code had been
revised to require nondiscrimination tests to assure
that 401(k) plans applied equally to all employees,
rather than being provided only to highly paid em-
ployees and managers. By 1984, there were over
17,300 companies with 401(k) plans, covering more
than 7.5 million employees. Total investments in
these plans were valued at $91.75 billion.
The Tax Reform Act of 1986 tightened the non-
discrimination rules. By the end of the decade, there
were over 97,000 companies with plans, covering
19.5 million employees. Assets totaled over $384 bil-
lion. Congress had finally found a motivating factor
to encourage employees to save money for retire-
ment, although not all employees participated in
the plans, which were voluntary. Although 401(k)
plans were available only to employees of for-profit
businesses, similar plans called 403(b) plans were
made available to employees of nonprofit organiza-
tions and educational institutions.
Although employers were made responsible for
establishing and administering the plans, that task
was typically outsourced to financial services compa-
nies, such as mutual funds or insurance companies.
When employees moved to new employers, they
were given the option of transferring, or “rolling
over,” their existing retirement plans to similar plans
administered by the new employers.
The tax code established restriction on prere-
tirement withdrawals from 401(k) plans. Unless an
exception applies, an employee’s 401(k) funds must
remain in the plan accounts until the employee
reaches the age of fifty-nine and one-half years. If
money is withdrawn prior to this age, the employee
must pay a 10 percent penalty tax, in addition to the
normal taxes. Some plans do allow employees to
borrow money from their retirement plans, but such
loans must be paid back with interest prior to retire-
ment.Impact The explosive growth in the number of
401(k) plans throughout the 1980’s was at least
partly attributable to their low cost to employers.
Such plans were typically less costly than the older
defined-benefit pension plans that many companies
had used. Companies are not required to contribute
matching funds, and if they elect to do so, the
amount of such funds is easily predictable in ad-The Eighties in America 401(k) plans 391