401(k)

Background

Originally intended for use by corporate executives, the 401(k) is now arguably the most famous section of the US tax code and a staple in worker benefits packages and personal finance guides (watch 101).

Roughly 70 million Americans with a total of more than $7T invested use these long-term, tax-advantaged accounts to build toward a more secure retirement.

What Is It?

A 401(k) is a savings account sponsored by employers to help workers prepare for retirement (read section 401(k) in the US tax code).

There are two types: traditional and Roth. Traditional plans defer tax payments until funds are withdrawn after age 59, while Roth plans take after-tax contributions but tax-free withdrawals. See pros and cons of each here.

Like most investment vehicles, 401(k) plans use the power of compound interest to allow savers to grow their wealth exponentially (how it works).

401(k) plans give employees more freedom over how they invest their savings than a traditional pension plan (see comparison). They are typically managed by investment firms that provide options for different mixes of stocks and bonds.

History

Since the mid-20th century, an expanded period of work-free, leisure-filled retirement for people over 65 has become a norm. That’s in contrast to most of human history, where older adults worked until they couldn’t anymore and then relied on support from others.

The widespread adoption of guaranteed pension plans, the passage of the Social Security Act, and the growth in GDP increased average income and helped prepare many workers for retirement.

By the 1970s, some firms wanted to allow their high-earning employees to place extra earnings directly into their pensions tax-free, but the IRS wouldn’t allow it. So in 1978, Congress passed a compromise, allowing employees to contribute to tax-deferred accounts up to an IRS-imposed limit ($23,000 in 2024).

Accountant Ted Benna popularized the 401(k) with his high-earning clients as a tool to get around high marginal income tax rates, which were as high as 70% in the early 1980s.

Employers began offering the accounts to allow workers to reduce their own costs, leading to an explosion in 401(k) adoption.

Critics

Top marginal tax rates have declined since the 1980s, lessening the tax advantages of 401(k) plans (see chart).

For many workers, a lack of access to 401(k) plans, excessive fees, and low wages have kept investment savings too low to achieve retirement goals. Roughly 17 million people in the US over the age of 65 are economically insecure.

Some critics claim companies off-loaded the risk of retirement savings to workers without the training to avoid volatile portfolio mixes. Amid the 2008 Financial Crisis, many 401(k) plans lost over a quarter of their value, an event that hit those near retirement particularly hard.

Some analysts, like professor Teresa Ghilarducci, argue for mandatory, guaranteed retirement accounts with a minimum return of 3% annually. Via the 2019 Secure Act, Congress has reformed aspects of the 401(k) to expand access and simplify its use.