What is a 401k Plan? History of 401k Plans & Annual Developments Timeline from 1978 - 2003

(November 13th, 2009)

A 401k plan is a retirement plan or a deferred arrangement where an employee is eligible to have a portion of his/her salary be deducted and put towards a retirement savings plan known as the 401(k). Most such deductions or ‘contributions’ to a 401k plan come out from gross income, and are therefore deductible from tax during year end. Money invested in a 401k plan can be invested in a wide variety of investments including Guaranteed Investment Certificates (GICs), stocks, bonds, US treasuries or in some cases real estate (in the case of a self directed IRA).

Pre-tax contributions to a 401k are taxed when withdrawn upon the age of 65 or retirement. Employers at their will, are eligible to make matching contributions on their employees’ 401k plans, however they are not required to by law. However, most companies do match their employee’s 401k contributions as a means of financial motivation to obtain & retain the highest calibre of talent. Annual contribution limit for 2009 is $16,500 for people less than 50 years old and those who are 50 years or over are eligible to contribute $16,500 + $5,500 = $22,000. The $5,500 is known as additional ‘catch up’ contributions for older people who have less time to save for their retirement. Current 401k contribution maximums are derived from the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRA) that stated the maximum annual deferral an investor could make will be capped at $15,000 in 2006, after which it will be indexed for inflation each year to $500 a year.

The US Congress in 1986 planned to replace defined benefit plans for civilian workers with a more meaningful 401(k) type plan, named after the source of its existence in the Internal Revenue Code. This gave rise to the existence of ‘defined contribution plans’ as we know it today, the 401k plan. The government was ready to endorse both defined benefit plans (pension plans) and defined contribution plans (qualified 401k retirement plans) depending on the needs of American’s working population. The Economic Growth and Tax Relief Reconciliation Act of 2001 made 401k plans extremely popular among Americans.

Precursor to 401k Plans of 1978

Prior to 1978 when 401k plans did not exist, there existed other types of deferral arrangements that allowed worker compensation to be deferred & contributed to Cash or Deferred Arrangement plans which then lowers tax liability for that year. Below, we outline some of the major developments in the world of 401k plans by each year:

i) 1978 – In 1978, the Revenue Act of 1978 was passed which then became the Internal Revenue Code (IRC) Sec. 401(k). Notice this is the part of the Internal Revenue code from which the term 401(k) plans is derived. This Act allowed employees to defer a part of their compensation from tax liability by contributing to a deferred arrangement plan. One of the earliest companies to adopt the 401k plan was the Hughes Aircraft Company that amended company rules to allow & adopt the 401k plan as a standard retirement saving arrangement.

ii) 1979 – Johnson & Johnson adopts the 401(k) retirement plan system; the first major company of its kind to do so.

iii) 1979 – 1982 – Several companies including PepsiCo, JC Penney, Savannah Foods & Industries, Johnson & Johnson, Hughes Aircraft Company, etc propose development & adoption of 401k plans for their many thousands of employees.

iv) 1981 – The Internal Revenue Service (IRS) proposed rules that sanctioned pre-tax contributions to 401k plans as the standard, as opposed to after-tax payments made to thrift savings plans. By 1983, studies showed that almost half of all the major employers in America were either offering a 401k plan or developing one.

v) 1984 – Developments were made to 401k plans thanks to the Tax Reform Act of 1984 (TRA '84) that required ‘non-discrimination’ testing of plans so that 401k plan contributions do not work in favour or the highly compensated employees who would receive larger tax breaks with larger amounts of contributions; thus highly compensated employees can only contribute a maximum allowable limit to 401k plans. At this point in 1984, over 17,303 plans had a 401k feature integrated into them, totalling $91.75 billion with 7.54 million active participants.

vi) 1990 – Over 97,614 retirement plans had 401(k) feature built in to them and number of active participants grew to 19.548 million Americans. Total assets in these plans were $384.85 billion.

vii) 1992 – The Unemployment Compensation Act of 1992 imposed a 20% mandatory withholding tax on lump sum distributions that are not rolled over to another qualified retirement plan such as a 401k, IRA or annuity plan. This act also allowed eligible distributions to be directly rolled over to other qualified retirement plans at the direct request of the participant.

viii) 1996 – The Small Business Job Protection Act of 1996 (SBJPA) went in to effect in 1996 that introduced SIMPLE plans (savings incentive match plans for employees) for employers with 100 employers or lesser and designed safe harbour methods for satisfying the non-discrimination tests applied to 401k plans for highly compensated employees.

ix) 1998 – The IRS issued a green light for 401k automatic enrolments for employees new to an organization. This was termed as a ‘negative election’ that allowed workers to automatically enrol in corporate 401k plans if they made no decision on their part, or did not opt out.

x) 2001 - The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) went in to effect. The EGTRRA brought about the following developments:

a. Increased the annual 401k deferral limits from $11,000 in 2002 to $12,000 in 2003, $13,000 in 2004, $14,000 in 2005 and $15,000 in 2006 and these limits will be indexed for inflation every year at a rate of $500 / year.

b. Permitted ‘catch up’ contributions to 401k plans for participants 50 years and over. The limits were $1,000 for 2002, $2,000 in 2003, $3,000 in 2004, $4,000 in 2005 and $5,000 in 2006 and indexed for inflation thereafter at a rate of $500 per year.

c. Introduced faster vesting requirements of employer matching contributions for workers who join 401k plans after 2001. The industry standard vesting schedules adopted would be either a three year cliff vesting schedule or six year graded vesting schedule.

d. Reinstated a special 401k coverage testing rule where a ‘controlled group’ will include both tax-exempt & taxable employers.

e. Allowed rollovers of 401k funds to IRA plans, 403b plans, 457b plans or traditional or Roth IRA if eligible.

f. Starting 2003, 401k plan participants will also be allowed to make IRA contributions if they are eligible.

g. Starting 2006, 401k and 403b plans will be allowed to permit participants to designate a portion of their elective deferrals to become after-tax Roth contributions.

xi) 2003 – As at 2003, total estimated number of 401k plans was 438,000 in America with assets totalling $1.9 trillion & 42.4 million active participants.