FFEF MONTHLY NEWSLETTER
FFEF provides Dollars & Sense a monthly educational newsletter free to our members and also available to the general public. Topics include budgeting, personal finance, financial literacy, saving and spending practices, and the sound use of consumer credit.
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Newsletter April 2010, Edition 5, vol. 4
The 401(k) Savings Plan — Saving for Retirement
The 401(k) Savings Plan is a plan that allows you to save for retirement. It is a long-term savings plan instituted by an employer in which a deposit is deducted automatically from your paycheck and invested by a plan manager. This deduction is most often expressed as a percentage of the total amount of pay. For example, if you receive $1,000 per month in wages and you choose to have 2% of your wages deposited into a 401(k) retirement account, $20 of your paycheck would go to the 401(k) and you would only pay taxes on the remaining $980.
In 1978, Congress amended the Internal Revenue Code and added section 401(k). The important distinction this section made was that employees will not be taxed on income they choose to defer (deposit) to plans they will withdraw from at retirement until the withdrawal is made. The law went into effect on January 1, 1980, and by 1983 almost half of the biggest companies in the U.S. were either offering a 401(k) plan or had plans to do so.
Originally intended for executives, the section 401(k) plan became popular with workers at all levels because 1) It allowed higher yearly contribution limits than the already existing Individual Retirement Account (IRA); 2) employers frequently deposited matching funds in the employees accounts; 3) 401(k) plans often allowed loans; and 4) employers stock was sometimes an investment choice.
By 1984, thousands of U.S. companies were offering 401(k) plans, and Congress passed additional legislation to ensure that the plans did not discriminate in favor of highly paid employees. They did this by putting a limit on the amount of pay that could be deferred. The Tax Reform Act of 1986 tightened the nondiscrimination rules even further and reduced the maximum annual 401(k) before-tax salary deferrals by employees.
In 1998, Congress passed legislation that allowed employers to put automatic deductions in place to have all employees contribute a certain amount into a 401(k) plan unless the employee actively chooses not to contribute.
One big reason for the instant popularity of 401(k) plans with employers was that these plans are less expensive for employers to maintain than the previous pension plans for every retired worker. With a 401(k) plan, the employer only has to pay the costs of administering the plan. Matching contributions by the employer are optional, meaning that employers can choose whether or not to include matching contributions in their plans. The federal regulations do not require that matching contributions be included. Employers can also choose to contribute some years and not others. For example, in years with strong profits, employers can make matching or profit-sharing contributions, and reduce or eliminate them in poor years. Also, 401(k) plan costs are much more predictable for employers, whereas the cost of previous pension plans could vary unpredictably from year to year.
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