As the most widely used and well-known retirement savings plans in the United States, 401(k) plans were the brainchild of benefits consultant Ted Benna. In 1980, 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.

History of the 401(k)

The term "401(k)" refers to Section 401(k) of the Internal Revenue Code. The provision allows employees to avoid taxation on parts of their income if they elect to receive it as deferred compensation rather than as direct pay.

However, the original provision did not allow for a separate account to be set up and funded through salary reductions. Benna petitioned the IRS to modify Section 401(k), which was written as part of the Revenue Act, and in 1981 the IRS complied. By the next year, several large companies began to offer new 401(k) plans to employees. Participants in 401(k) plans could then use their deferred income to make investments without being taxed on gains.

These new accounts quickly became popular. In 1983, more than 7 million employees participated in a 401(k) plan. By 1991, that number had reached 48 million, and the combined assets of all 401(k) plans surpassed $1 trillion in 1996.

In 2001, the United States Congress passed the Economic Growth and Tax Relief Reconciliation Act, which allowed for the so-called "catch-up contributions" for participants age 50 and older. The act also allowed for companies to offer Roth 401(k) accounts, which require post-tax contributions but provide the benefit of tax-free growth and distribution.

Purpose and Uses of the 401(k)

Modern 401(k) plans were not an intentional design of the U.S. government or the Internal Revenue Service. Indeed, the federal government twice tried to invalidate 401(k) plans in the late 1980s. The concern was that tax receipts would fall too fast as more workers funded their retirement plans.

Employees receive two significant benefits from 401(k) plans and other tax-exempt retirement accounts: first, there is the obvious tax benefit. Second, employees have a way to protect their retirement savings from losing real purchasing power through inflation. On the downside, 401(k) plans are riskier for employees than defined benefits plans, which are federally guaranteed.

There are obvious benefits to employers as well. For instance, the costs of offering retirement benefits have declined significantly. Small businesses particularly benefit from the new defined contribution plans; the plan allows these businesses to offer similar benefits packages to employees as those found in larger companies, leveling the playing field.

The federal government encourages the use of 401(k)s and other retirement plans. Even though tax receipts decline as more people participate, a population that funds its own retirement ends up reducing government expenditures on welfare programs for the elderly.