401 (k) Plan

A 401 (k) plan is a tax-deferred, defined-contribution retirement plan. The name comes from a section of the Internal Revenue Code that permits an employer to create a retirement plan to which employees may contribute a portion of compensation on a pre-tax basis. This section allows the employer to match employee contributions with tax-deductible company contributions. Earnings on all contributions are allowed to accumulate tax-deferred. In early 1995, 401 (k) plans ranked among the most popular and fastest-growing types of retirement plans in America.

Basics of 401 (k) plans

In benefits parlance, employers offering 401 (k)s are sometimes called "plan sponsors" and employees are often known as "participants." Most 401 (k)s are qualified plans, meaning that they conform to criteria established in the Economic Recovery Tax Act of 1981 (ERTA). ERTA expanded upon and refined the Employee Retirement Income Security Act of 1974 (ERISA), which had been enacted to protect participants and beneficiaries from abusive employer practices and created guidelines that were intended to ensure adequate funding of retirement benefits and minimum standards for pension plans.

Basic eligibility standards were set up with this legislation, including a minimum age of 25 years and a predetermined length of service before contributions were made. Some union employees, nonresident aliens, and part-time employees were excluded from participation.

The new 401(k)s incorporated many attractive features for long-term savers, including tax deferral, flexibility, and control. Taxes on both income and interest were delayed until participants began receiving distributions from the plan. Rollovers (direct transfer of a 401 (k) account into another qualified plan, such as a new employer's 401 (k), an IRA or (self-employed pension plan) and emergency or hardship loans for medical expenses, higher-education tuition, and home purchases, allayed participants' fears about tying up large sums for the long term. While there are restrictions on these loans' availability, terms, and amounts, the net cost of borrowing may be quite reasonable because the interest cost is partly offset by the investment return. Employees may also receive lump sum distributions of their accounts upon termination. If an employee elects to take his or her distribution in cash before retirement age, the employer is required by law to withhold 20% of the distribution. If the account is rolled over into another qualified plan, nothing is withheld. Employees' self-determination of investments has allowed tailoring of accounts according to individual needs. For example, younger participants may wish to emphasize higher-risk (and Potentially higher-return) investments, while employees who are closer to retirement can focus on more secure holdings. These features have been refined over the years through legislation, especially after the Bovernment realized the tax revenue losses engendered by the popular plans.

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) reduced maximum contribution limits that had been set by ERISA, introduced the "top heavy" concept, and revised the rules for federal income tax withholding on plan distributions. Most plans allowed employees to defer 1% to 10% of current compensation, but such internal limitations have been bound by compensation and contribution ceilings enumerated in TEFRA and subsequent legislation. These limits have made senior executives and other highly paid employees the big losers under 401 (k) plans. In 1986, the amount an employee could defer annually under such programs was reduced from $30,000 to $7,000. In addition, the compensation that could be considered in determining an employee's deferral was limited to $200,000. The $200,000 limit, which had previously been increasing on an annual basis through a cost of living adjustment, was limited to $150,000 per year under the 1993 tax law. Mandatory "top heavy" tests that prevent 401 (k) programs from favoring highly-compensated employees restrict the amount that highly paid employees can contribute to 40l (k) plans.

Known as "nondiscrimination tests" in the benefits industry, top heavy rules separate employers and employees into two groups: those who are highly compensated and all others. The amounts that the highly paid employees may defer is based upon what the lower-paid employees deferred during the year. A simplified example helps illustrate this concept: if the average lower-paid employee only contributed 2 % of his or her compensation to the corporate 401 (k), high-paid employees may only divert 4% of their pay. This test adds a second level of limitation on the amount that highly paid employees can defer, often lessening it from legally established limits. Benefits and tax specialists have, of course, devised strategies to circumvent these restrictions, such as 401 (k) wrap-arounds, "rabbi trust arrangements," and other "non-qualified" plans that consciously and legally operate outside the bounds of "qualified" 401(k)s.

The Deficit Reduction Act of 1984 (DEFRA) continued the government's revenue-raising — and often 401 (k) — limiting-provisions. The Retirement Equity Act (REACT or REA) of that same year helped protect spouses of plan participants by requiring that qualified plans provide numerous survivor benefits. REA also reduced the age at which employees became eligible to contribute to a 401 (k) from 25 to 21. The Tax Reform Act of 1986 (TRA 86) incorporated some of the most extensive, revenue-raising changes in 401 (k) criteria since ERISA by imposing new coverage tests and accelerating vesting requirements. Although much of this legislation was intended to benefit employees, it has also been cited as the principal cause of the voluntary termination of thousands of pension plans — a total of 32,659 between July 1987 and September 1988. These terminations eliminated future pension benefits for hundreds of thousands of workers.

During the 1980s, many plan sponsors offered employees only two investment options for their 401 (k) account: an insurance company's guaranteed income contract (GIC) and a profit sharing plan. Insurance companies often had full — service capabilities in place and the GICs, with their high interest rates, garnered the lion's share of plan sponsors and participants. Statistics from the Employee Benefit Research Institute and the U.S. Department of Labor showed that about 40% of the assets in 401 (k) plans was invested in GICs, which placed the burden of performance on employers and their fiduciary agents. But a rash of insurance company failures late in me decade prompted many portfolio managers to increase die number of investment alternatives.

A new provision, ERISA rule 404 (c), that went into effect January 1,1994, stipulated several changes in me ways employers administered their programs. First, plans were required to offer at least three distinctly different investment options mat spanned the entire investment spectrum, in addition to the employer's stock. Qualified plans were also compelled to educate participants by providing adequate information about each investment option, thereby enabling employees to make informed choices among them. Finally, employers and their 401 (k) administrators were obliged to make more frequent performance reports and allow more frequent changes in investments. These changes have shifted the responsibility for choosing investments from employer to employee, thereby limiting the potential liability of employers for investment results. Although 404 (c) was not mandatory, industry observers predict that many plan sponsors would comply with the new provisions in the interest of happier, more financially secure employees.

It was anticipated that the enactment of provision 404 (c) would trigger an investment shift among 40l (k)s from GICs and employer stocks to mutual funds. As of the end of 1992, mutual funds held about 24% of the then — $410 billion 401 (k) market, but that percentage was expected to grow dramatically by die end of the century. Mutual funds were seen as an easy way for employers to comply with 404(c) because of the benefits and services they afforded, including access to top professional money managers, instant diversification, portfolios managed according to specified investment objectives and policies, liquidity, flexibility, and ease and economy of administration.

At the end of 1993, surveys showed that approximately 70% of eligible workers, or 16 million people, participated in a 401 (k) plan, and assets invested m such programs exceeded $440 billion as of January 1994. Defined-contribution plans overall, including 401 (k), profit-sharing and thrift savings plans are expected to grow threefold, to more than $1 trillion, by the end of the century.

The shift from defined-benefit plans to defined-contribution plans such as 401 (k)s has had both positive and negative ramifications for both employees and employers. On the downside, employees have been compelled to shoulder more of the financial burden for their retirement, and employers have had a larger responsibility to report their application of pension funds. But most observers have applauded the movement. Employees have gained greater control over their retirement assets. The plans provide immediate tax advantages as the contributions are not subject to federal income taxes nor to most state and local taxes. They also provide long-term tax advantages, as earnings accumulate tax-free until withdrawal at retirement when withdrawals can receive favorable tax treatment. Employers have been able to share or even eliminate their pension contributions. And if employers do choose to contribute, they too get a tax deduction. 401 (k)s have evolved into a valuable perk to attract and retain qualified employees. Employers can even link contributions to a profit sharing arrangement to increase employee incentive toward higher productivity and commitment to the company.