In 1978, Congress decided that Americans needed a bit of encouragement to save more money for retirement. They thought that if they gave people a way to save for retirement while at the same time lowering their state and federal taxes, they might just take advantage of it. The Tax Reform Act was passed. Part of it authorized the creation of a tax-deferred savings plan for employees. The plan got its name from its section number and paragraph in the Internal Revenue Code -- section 401, paragraph (k).
Ted Benna, who was a benefits consultant, actually came up with the first version of this plan. His plan was officially accepted by the IRS and proposed regulations were issued in 1981. In 1982, taxpayers were able to take advantage of this new plan for the first time. It took almost 10 years, but final regulations were eventually published in 1991.
401(k) plans are part of a family of retirement plans known as defined contribution plans. Other defined contribution plans include profit sharing plans, IRAs and Simple IRAs, SEPs, and money purchase plans. They are called "defined contribution plans" because the amount that is contributed is defined either by the employee (a.k.a. the participant) or the employer.
What makes a 401(k) different?
Four things differentiate a 401(k) plan from other retirement plans.
1. When you participate in a 401(k) plan, you tell your employer how much money you want to go into the account. You can usually put up to 15 percent of your salary into the account each month, but the employer has the right to limit that amount. It might be worth your while to rally for a higher limit if it isn't as high as you would like it to be. The IRS limits your total annual contribution (something over 11K per year).
2. The money you contribute comes
out of your check before taxes are calculated, and more importantly, before you ever have a chance to get your hands on it. That makes the 401(k) one of the most painless ways to save for retirement.
3. If you're lucky, your employer will match a portion of your contribution. Your employer wants you to participate in the plan because of compliance issues we'll talk about later. The matched amount they offer (the free money part) is your incentive to participate.
4. The money is given to a third party administrator who invests it in mutual funds, bonds, money market accounts, etc. They don't determine the mix of investments -- you do that. They usually have a list of investment vehicles you can choose from as well as some guidelines for the level of risk you are willing to take.
Something to think about
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