The 401(k) turns 40 on Sept. 2, and it is no exaggeration to say that it has revolutionized retirement for millions of Americans, providing them a way to spend the last phase of their lives with greater financially security than previous generations.
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The 401(k) plan retirement system now holds $2.8 trillion in assets on behalf of more than 50 million active participants and millions of former employees and retirees, according to the Investment Company Institute.
Before Congress passed the Employee Retirement Income Security Act (ERISA) in 1974, many workers did not have any type of income source to cover their retirement years other than Social Security and whatever savings they had personally set aside. This was especially true if you worked in the private sector for a small company. Even if you were lucky enough to be employed by a firm that offered a traditional pension, you had to stay with the company for a long time to qualify for it.
A New Way to Save
The primary differences between a traditional pension and a 401(k) come down to flexibility, responsibility and portability.
A pension is considered a defined benefit plan because employees are promised a specific amount of income when they retire. An employer must make mandatory contributions to the plan and is on the hook to pay the expected benefit. The downside is that it is extremely costly for employers to provide this type of guaranteed income, both in terms of the size of the contributions required and the regulatory red tape. Just consider the many state and local governments that are raising taxes or reducing everything from cops on the street to school athletic programs as they struggle to come up with the money their retiring employees expect to receive. In some cases (Detroit, Stockton, Calif.) they are simply throwing in the towel and declaring bankruptcy.
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In contrast, a 401(k) plan– named after the section of the tax code by which it is governed- does not guarantee a certain retirement benefit. It falls into the category of defined contribution plan because the amounts that employers and employees may contribute are spelled out. The income a retiree receives depends upon how much the saver and the employer contribute (both can vary) and how well the investments (chosen by the employee) perform.
The tax incentives for 401(k)s are substantial. Contributions to an employee’s account- whether they are made by the employer or the employee- are tax deductible. Returns earned by the investments in an individual’s account also escape taxation as long as they remain in the account. No income tax is due until the money is withdrawn in retirement, allowing for years of tax-deferred compounding.
Another advantage is that unlike a pension plan, an employee quickly becomes vested in the value of his 401(k) account. The account can also move with career and job changes. The fact that employees own their accounts and can “roll” the assets into the plan of their new employer or an Individual Retirement Account (IRA)- and thereby continue to avoid taxation- provides the potential for someone to accumulate a significant amount of money over their working life.
Workers Bear the Responsibility
The main criticism of 401(k)s is that they shift the burden of providing an adequate retirement income from the employer to employees, most of whom have little or no experience with determining how much they need to save or how to choose a suitable mix of investments.
Congress and some financial experts have questioned how 401(k) participants will fare when they actually retire. Will they have contributed enough during their working years to provide them with sufficient income when they retire? How will their investment choices perform? Will they withdraw too much and run out of money prematurely?
A groundbreaking national survey by money manager T. Rowe Price recently found that the answer is overwhelmingly positive. The education and tools that both investment firms and employers provide to 401(k) participants seem to be making an impact. Recent retirees report that although they are living on less income than when they were working, they are very satisfied. In general, they recognize the importance of keeping their retirement money diversified among different investments and are being cautious about their withdrawals, aware that their account needs to provide them with retirement income for decades.
Making it Easier
In recent years, a number of changes have been made in an effort to encourage workers to save more in their 401(k) plans and to simplify the process of deciding how to invest their contributions. Attorney and CPA Bruce Tannahill in Scottsdale, Ariz., has co-written a comprehensive and comprehensible handbook on 401(k) plans. In his view, here are the most significant recent improvements:
Auto-enrollment. This would allow an employer to immediately open a 401(k) account for every employee who meets the criteria and to begin both company and employee contributions to the plan. An employee must opt out if they choose not to participate. Few do. After a while, most do not even notice the money being deducted from their paycheck. In Tannahill’s words, you get to “pay yourself first without having to think about it.”
Automatic contribution increase. With this rule, an employer can annually increase the amount of pay that an employee contributes to the plan by 1% until the contribution rate reaches a certain level. “Often your salary goes up 2-3% each year,” says Tannahill. “Your employer is just taking a little of that increase and putting it into your 401(k) account. This allows you to increase your savings and still see an increase in pay.”
Target Date and/or Asset Allocation funds. A major reason people do not take advantage of the 401(k) plans offered by their employers is due an overwhelming fear about choosing the investments for their account. “Even Bill Gates doesn’t do his own investing,” says Tannahil. “Many people are very skilled at what they do, but they don’t study the financial markets.”
To solve this problem, most plans now offer professionally-managed mutual funds which make the investing decisions for you based upon either how much time you have before you expect to retire or how much risk you are comfortable with. (It’s probably less than you think.)
Rah, Rah Roth
Another major improvement to 401(k) plans is the addition of a Roth option. If your employer offers this, the money that you invest in that portion of your plan will not be tax-deductible. Instead, the tax break occurs when you are retired and start taking income out of your account. Provided basic rules are met, withdrawals from a Roth account are completely tax-free.
The advantage of a Roth 401(k) account can be significant. In Tannahill’s words, while the government gives an incentive to contribute to a regular 401(k) account by not taxing the money put into it, “they take that incentive back when you retire by taxing both your contributions and your earnings as you withdraw income.” When you contribute to a Roth 401(k) account, you pay income tax on when your contribution is deducted from your paycheck, but not on the appreciation. “With a Roth, you can reduce the long-term taxes because you don’t pay tax on the earnings,” says Tannahill. He also points out that it’s not an all-or-nothing proposition. If your plan has a Roth option, you can divide your contribution between that and a regular 401(k) account.
Despite the efforts of employers and 401(k) providers to encourage and educate employees about participating in their company’s plan, many of us make basic mistakes that can result in a significantly smaller account balance at retirement. Tannahill, who is also a licensed financial advisor, says it’s important to:
- Start contributing as soon as you can. “The time value of money is a phenomenal ally if you use it. The earlier you start, the more you benefit from compounding over time.” He stresses that even if you are close to retirement, you can benefit from contributing. “Because on the day you retire you don’t take out all the money. You may live to be 80 or 90. That’s a long timeframe for money to grow and accumulate.”
- Would you turn down a raise? Then don’t ignore employer matching contributions. Many employers will match the amount you put into the plan dollar-for-dollar up to a certain percentage. That 3% your company is offering to put into your account is essentially an extra 3% in salary. But you lose it if you don’t contribute 3% yourself. “It’s free money!” says Tannahill.
- Be sure to keep your retirement money in a tax-sheltered account. If you change jobs or retire, move your 401(k) assets into your new employer’s plan or an IRA. If you take it out, you will not only have a big tax bill, your savings will no longer benefit from tax-sheltered growth.
One final thought: Shortly before the end of every year, 401(k) participants must decide how much they want to invest in their plan in the new year ahead. If you are not already maxed out, consider increasing your deferral rate by 1-2% each year until you reach the limit. The future 80-year old who lives inside you will be extremely grateful.