How 401(K) Plans are Structured

The Demand for Work Sponsored Retirement Plans

There are three main avenues for people to pursue their retirement goals, which are government sponsored benefits, our saving for retirement on our own, and our having a retirement plan set up through our employer.

Having our employer help us manage our retirement for us is a concept that has been around for a long time and remains the main driving force behind retirement savings today.

Our concern for our retirement fate led to the emergence of the employer sponsored pension plan, which began in the United States in 1875 with the American Express company providing fixed retirement benefits to their retirees. Back in those days, a lot of businesses were small and of limited resources, where such a scheme would have been beyond their means, but larger companies did have the means for this.

During the next few decades, more and more large employers started offering fixed benefit pension plans, and from the early momentum that was created, having a pension plan was seen more and more as an important consideration when offering one’s employment.

As the demand for pension plans arose, this increased the pressure on businesses to offer one in order to stay competitive. Labor unions further drove this demand and this became a key element in their negotiations, leveraging their power to forge out better pension plans for their workers.

Fixed benefit pension plans aren’t just expensive to companies, they are also fraught with risk, as fixed benefits must be paid regardless of the market returns of the investments that they set aside to fund these benefits.

It is far better for employers to structure their retirement plans to mirror the market conditions of the money invested for this purpose, where the benefits, and the amount accrued to be used by a given employee, will vary depending on how much has been earned from the money being invested.

While this arrangement has not been seen as a popular one among employees, who would understandably prefer a scheme that is more reliable, a certain amount of money a month for life when they retire, over the years we have come to accept their employer simply helping them to save for their retirement and contributing along with us toward that goal.

This is called a defined contribution plan, although in truth we should be calling it a variable benefit plan, or actually a savings vehicle that has a variable future value depending on both how much is contributed and what returns have been achieved with this money. This may not be the ideal for employees, or they at least may not see this as the ideal, but if defined benefit plans aren’t being offered, it becomes the best choice by default.

The Role of the Government in Promoting Work Sponsored Retirement Plans

While the government has an interest in taxing people, if we are setting money aside for retirement, there is a good argument out there that we should be allowed to declare it as taxable income when it is used.

This all deals with the concept of progressive taxation, where one’s income level determines the amount of income tax that we are subject to paying. The main principle behind this is that those who earn more are seen as being able to afford to pay a higher percentage of it in income tax.

If we are not using a certain amount of money, and an amount that is deemed appropriate by the government to set aside, we are not spending this money now and should have the option to pay income tax on it later, at the time that is needed.

In 1974, Congress passed a bill that allowed individuals to defer income tax on qualified contribution amounts to an individual retirement account, or IRA. This did not address employer sponsored plans though, and individuals lobbied Congress to come up with an arrangement that allowed defined contribution employer pensions to receive a similar tax treatment.

In 1978, a new section was added to the tax code of the United States, section 401(k), which permitted such deferral with private sector pension plans, although at the time it was fairly obscure.

Two years later, a benefits consultant named Ted Benna figured out that this section could be used to set up tax deferred pension plans, and the first 401(k) plan was put into place by the Johnson Companies.

Although the 401(k) plan was born out of the original idea of the IRA, 401(k) plans not only allow for employer contributions to be tax free, they also come with much higher contribution limits from taxpayers. In 2006, the Roth 401(k) was added, 20 years after the Roth IRA first emerged, which increased the flexibility of the 401(k) plan as it had for IRAs.

401(k) plans have become enormously popular, and today, about two thirds of all workers in the private sector have access to a 401(k). While 401(k) plans are limited to those working in the for-profit public sector, there are similar plans that apply to government workers and those in the non-profit sector that are very similar, allowing for tax advantages for investing for one’s retirement.

With Social Security being seen by many as being in trouble in the future, it has become even more imperative for the U.S. government to provide incentives for people to do better at saving up for their own retirement, as they will at the very least have to bear more of the burden in the future as the cost of Social Security becomes one day unmanageable in its present form.

IRAs and especially 401(k) plans and other defined benefit pension tax treatments are now an integral part in people’s retirement fortunes, even though a lot of people don’t give this proper heed and do not save enough or perhaps not set aside anything for their retirement in spite of the tax advantages involved.

We are a society of spenders overall and our zeal to consume is famous, or infamous, depending on how you look at it. Those who sell us all the things we buy are no doubt delighted at our consumption rates, but in the end, we need to be aware that these decisions may impact our retirement years, and we should take a longer-term view of the proper uses of our income a lot more than many of us currently do.

The Advantages of 401(k) Plans

The first advantage of a 401(k) plan is the ability to either defer income tax payable on contribution amounts to a future point in time, and specifically, in retirement. It’s not even the fact that we may pay less tax on this income in retirement than we would now that’s the big thing, although that does factor into things when we need to decide between a standard 401(k) and a Roth 401(k).

If we only had the choice between deferring tax on money or not, as was the case prior to the Roth forms of retirement plans, we’d still want to do this even though there would be no tax savings later, meaning that our tax bracket would not decrease. This is because we’d get to use this money for all those years and is essentially an interest free loan made to us by the IRS.

What happens when we defer taxation, promising to pay tax on these amounts later, is that we get to invest this money over time and can rack up some pretty significant returns on it over the years. We get this benefit from both a standard 401(k) plan and a traditional IRA, although we can stash away a lot more into a 401(k) as well as generally having our employer match these contributions.

Employer matched contributions are what really set 401(k) plans apart from IRAs, and although these contributions form part of one’s overall compensation, this at least has the appearance of additional compensation, the employer’s money being added instead of our own.

In actual fact, when they decide how much they are going to pay us now as well as later, they do of course factor this in, so this is more like forced contributions than anything. Regardless of how you look at, employers do set aside a certain amount of money that we will not receive if we don’t take advantage of these matched contributions. That may actually be seen as a more compelling reason, as leaving employer’s money on the table isn’t as bad as leaving our own money unclaimed.

We might expect that if the demand was high enough, employers would be convinced to allow us to opt out of these schemes, and receive the money in cash straight up instead of earmarking it for matched contributions or other forms of retirement benefits, but the idea of saving for retirement at least remains an extremely popular one, even though so many people do not follow through with this plan well enough.

In the end, it can easily be seen as for people’s own good that their compensation is broken up this way, making them choose between spending less and contributing to their retirement fund so they can receive this money set aside for them, and walking away from the money. This certainly does work in many cases to get people to do the right thing more, focusing more on their long-term financial health and less on present gratification.

401(k) contributions also stand out by virtue of their being made pre-tax, so that the tax savings are immediately realized as the additional tax simply isn’t paid. This can make it a lot easier to adjust to the net amount received after contributions as one simply does not see the money on their pay check.

If we receive the tax benefits post-tax, like we do with a traditional IRA, there is a real risk that we will not recontribute the tax savings into the IRA, and we may not even have the room to do that if we are maxing out our contributions on our own each year. If we receive a deduction on our taxes and just spend the money, this leaves us without having saved any of that and the tax liability on the principal amount remains.

If we contribute $1000 to a retirement fund post-tax, and receive $250 back at tax time, it is this $250 that is the deferred tax. Let’s say we expect to pay $150 in income tax on this $1000 in retirement, but we spend the $250 on something else and we still have to pay the tax on this in retirement.

This perhaps makes things a little better for us in the present but makes things a little worse in the future instead of better. This is a mistake a lot of people make with traditional IRAs, but the pre-tax contributions of 401(k)s prevent this from happening, since the tax savings are essentially left in the plan as we should want it to be.

In both cases, we are left with $1000 in our plan, with the tax to be paid later, but in the case of a 401(k), it has only cost us $750 of net money, instead of putting in $1000 and getting $250 back later. If we can use this $250 to make an additional contribution, then things will work out close to the same, but again, we often do not do this or we might not even be able to.

On the other hand, contributing pre-tax can have us not contributing as much as we should, as we should calculate how much we can contribute as a percentage of our net income. So, if we can contribute $1000 of net income, that’s how much we should be putting in, which will mean that our actual contribution will be $1333 if we are in a 25% tax bracket. This extra $333 is the deferred tax that we will use to get returns on over the years and this is where the real power of a deferred tax strategy comes from.

401(k) plans give us not only this ability, they also involve our employers kicking in additional amounts, a 50% match or even a full match in some cases. Not all employers match contributions in 401(k)s, but a lot do, and if they do, we should definitely be looking to take as much advantage of this as we can.