Since 401(k) retirement savings plans first appeared in the early 1980s, they have grown rapidly. Today, they are one of the most popular and widespread employee benefits. A 401(k) plan offers employees the opportunity to defer a portion of their compensation into individual tax-deferred accounts on a pretax basis, thus avoiding income tax on those “deferred compensa­tion” amounts until the money in their accounts is distributed.

Additionally, the earnings on those amounts are tax-deferred. This option of receiving money as either part of one’s compensation—as cash, in other words—or as deferred income, is the essence of the term “cash or deferred arrangement” (CODA).

In this article, we’ll look at some of the key benefits 401(k)s provide to both employees and employers, as well as some important practical considerations. Many thanks to Arris Murphy, J.D., Contributing Editor to BLR’s The 401(k) Handbook, from which the material for this piece originated.

History of 401(k)s

Although CODAs have existed in various forms for many years, federal law did not officially recognize them until 1978, when Congress added Section 401(k) to the Internal Revenue Code. Recognizing that it was creating a very attractive tax shelter with a significant potential for abuse, Congress attached numerous “strings” to 401(k) plans to ensure that taxpayers would use them for their intended purpose—saving for retirement—and not for other purposes, such as vaca­tions or a child’s college tuition.

Similarly, concerned that some employers might exploit 401(k) plans to favor their highest-ranking employees, Congress also created a series of rules and tests that every 401(k) plan must pass to ensure that it does not discriminate in favor of highly paid employees.

Since 1978, the requirements associated with those two simple concepts—discouraging employees from withdrawing the money in their 401(k) plan accounts before retirement and prevent­ing employers from discriminating in favor of highly paid employees—have been fleshed out in a series of laws, amendments to existing laws, proposed and final regulations from the Internal Revenue Service (IRS) and the U.S. Department of Labor (DOL), and other administrative guidance from the IRS and the DOL.

More recently, attention has been given to encouraging employees to save more through automatic enrollment in the plan, automatic escalation in contribution percentages, and catch-up contributions for employees aged 50 and older.

401(K) Advantages to Employers

Why should you consider adopting an employee savings or 401(k) plan? Here are some possible objectives:

• To improve the benefits package you offer, at little cost to your organization
• To allow employees to supplement their future retirement income
• To provide a highly mobile work force with a suitable way to save for retirement
• To provide an alternative to the defined benefit plan as a vehicle for retirement savings
• To enable employees to take advantage of income tax deferral

Employee Communication Is Key

Perhaps no other employee benefit plan requires as much careful attention to employee com­munication as a 401(k) plan. Unlike employee savings plans that use after-tax contributions, a pretax 401(k) plan has no place in an employer’s benefits program unless the objective is to supplement an existing retirement program or to provide a sole source of retirement income. When used in this manner, the distinction between a 401(k) plan and an after-tax savings plan must be clearly communicated to employees.

Employees may react negatively to many of the limitations and restrictions of a 401(k) plan. It will help in the communications process if the reason for these limitations is explained in a nontechnical manner. It should also be pointed out to employees which plan provisions are employer-generated and which are legal requirements. This is particularly important with regard to withdrawal restrictions and penalties.

Special provisions governing hardship withdrawals and loans require considerable attention in the communications process. The most important consideration is ex­plaining to employees that what may appear to be their money is actually money being disbursed or lent from a legal entity, the plan trust. The many restrictions associated with loans and hard­ship withdrawals are difficult to comprehend when it appears that they are being applied to money that is being held in an employee’s personal account.

To a large extent, an employee’s perspective of the advantages of a 401(k) plan can be shaped by the information provided by the employer and by the design of the plan itself. In their desire to obtain a high level of employee participation, some employers have tried to present 401(k) plans as vehicles to save and to accumulate tax-deferred earnings, but have failed to point out that this savings is for retirement. Nevertheless, as long as all rules are communicated, em­ployees can enjoy all the benefits of participating in a 401(k) plan:

• Saving through the convenience of payroll deductions;
• Accumulating substantial capital through tax-deferred savings and receiving employer-matching contributions if they are available;
• Reducing current income tax obligations;
• Supplementing retirement income; and
• Saving for large near-term objectives such as paying for a home or college education.

This last objective deserves special attention. Although it is a very common employee ob­jective, it may be an inappropriate reason for participating in a 401(k) plan because making a withdrawal from a 401(k) plan before age 59½ generally results in tax penalties. Also, deferring income for only 5 or 10 years and making a withdrawal (assuming that hardship withdrawals are permitted under the plan) while a participant is still actively employed may mean having to pay more income tax, not less, if tax rates rise.

Alternatives to 401(k)s

Employers that are concerned about allowing employees to meet different objectives through a 401(k) plan should seriously consider establishing an employee savings plan that allows both before-tax and after-tax savings. Recently, employers also have established in-plan Roth accounts, which require a current income tax on the amount contributed but permit tax-free distributions of the contribution amount and earnings in retirement.

These alternatives provide a savings vehicle for employees with near-term objectives and for employees who want to save for retirement but would rather be assured of penalty/tax-free access to their money for emergencies.

Additional Resources

• The 401(k) Handbook
• 401(k)Plan Distributions and Taxation
• Explaining 401(k) to Employees (Training Talk)