401k History

Research Paper

401(k) and Its Affect to Taxpayers

Amelia Budiman

Devry University

Federal Taxes and Management Decisions (ACCT-553)

Professor: MYRON LUBELL, DBA, CPA

11/22/2015

401(k) Explained

        According to the Internal Revenue Services (IRS) (2015), 401(k) is a qualified plan that provides cash or deferred arrangement (CODA) which allows an employee to elect to have the employer to contribute a portion of the employee’s wages to an individual account under the plan. Employers have the discretion whether or not to make matching contributions to their workers' 401(k) accounts.  The underlying plan can be a profit-sharing, stock bonus, pre-ERISA money purchase pension, or a rural cooperative plan. Normally, deferred wages (elective deferrals) are not subject to federal income tax withholding at the time of deferral, and they are not reported as taxable income on the employee’s individual income tax return. Taxes are only paid when the contribution is withdrawn. 401(k) plans adopted its name after the section of the Internal Revenue Code 26 U.S. Code § 401k in which they appear, and generally apply to private-sector employers. Most 401(k) plans consisted of spread of mutual funds composed of stocks, bonds, and money market investments. (Wall Street Journal (WSJ), 2015)

There are several types of 401(k) plans: traditional 401(k), Safe Harbor 401(k), and SIMPLE 401(k). The last one was created with small businesses in mind; therefore it is a lot simpler and cost-efficient compared to both traditional and Safe Harbor. In addition, SIMPLE 401(k) is only available for employees who worked in a company with 100 or fewer employees and received compensation at least $ 5,000 in preceding calendar year. (Internal Revenue Service (IRS), 2015) The simplest way to adopt 401(k) plan is to utilize “right of the shelf” plans which are often loosely referred to Pre-Approved plans due to their simplified nature which makes them commonly selected in the U.S. financial industry. (Sacks, 2014, p.144)  There are also Individually Designed Plans which are more costly, complicated and suitable for larger companies. (Sacks, 2014, p.145)

Brief History of 401(k)

Cash or deferred compensation arrangements which were (and still are) the main outlet for pensions and retirement plans for Americans have been secured by the establishment of The Employee Retirement Income Security Act of 1974 or ERISA. ERISA is a federal law that sets minimum standards for retirement plans in private industry (United States Department of Labor (DOL), n.d.) which also mandated a study of salary reduction plans that influenced 1978 legislation creating 401(k) plans. (Employee Benefit Research Institute (EBRI), 2005) Four years later, The Revenue Act of 1978 included a provision that became Internal Revenue Code (IRC) Sec. 401(k) which stated that employees are not taxed on the portion of income they elect to receive as deferred compensation rather than as direct cash payments. This act added permanent provisions to the IRC, sanctioning the use of salary reductions as a source of plan contributions. The law went into effect on Jan. 1, 1980. Regulations were issued in November of 1981. (EBRI, 2005)