What In The World Is A 401k?

"When you retire you switch bosses from the one who hired you to the one who married you."
- Gene Perret

When I first began my career, I was ashamed to admit that I really didn't know what a 401k was. Although I did my undergrad in business, we never discussed retirement, finances, or personal budgeting. No professor ever did a lesson on 401ks, IRAs or investments. However, everyone was telling me that I needed to save for retirement and that I needed start my 401k. So what did I do? I began to do research and eventually took courses to understand what a 401k really is and what was the history behind it.

Later in life, I realized that I wasn't the only one that didn't know what in the world was a 401k. Many people don't really know what a 401k is and how it works, and many of them think that a 401k is the only option when it comes to retirement. My goal today is to give you a quick history of the 401k and detail more or less what it does. In the next few blogs I'll explain the different types of 401ks that exists so that you can make better decisions when choosing a plan and hopefully manage your 401k much better. Let's get started.

The Era of Pensions

The 401k actually has a short history. Before they existed, some companies offered a pension plan to their employees. The Center for Economic Policy Analysis at the New School for Social Research believes that the old-traditional pensions would do much better now than the traditional 401k we have now. However, most workers in the private sector did not have a pension plan and according to the Center of Research on Retirement Income at the Employee Benefit Research Institute, most employees working in the private sector weren't working long enough with a single employer to qualify for a full pension. Now there are few employers that offer pension plans and the proportion of private workers participating in traditional pension plans is less than 20%, according to the Department of Labor. 

The Birth of the 401k

In 1978, after much debate between employers and the IRS, the Revenue Act of 1978 included a new section code which allowed employees to not be taxed on the portion of income they elect to receive as deferred compensation rather than as direct cash payments. This idea was introduced by Ted Benna, a benefits consultant for Johnson and Johnson and over the next few years the law went through different variations. Finally, the regulations were issued in November of 1981 and shortly after, companies like Johnson and Johnson were adapting 401k plans for their employees. This was called the Internal revenue Code (IRS) Sec. 401 (k). Many employers adopted the 401k plans simply because they were inexpensive.

The Evolution of the 401k

Originally, the traditional 401k plan only had two investing options: a conservative fund similar to a money market fund and a stock fund. That was it.  However, over the years the 401k plans seemed to have gotten more complicated. Many traditional 401k plans now offer more than 15 investment options 'depending on your style'. This becomes very confusing for an average employee who has no investment knowledge. In fact, it's confusing even for those that do have investment knowledge.

So, how does a 401k work and what types of 401k plans exist? That will be the topics of my following blogs. If you're interested in learning more about the history of 401k plans, or you just want to do a little bit more research yourself, please feel free to use the following resources:

The Surprising Origins of Your 401(k) - an article from Nasdaq.com

401(k) - Wikipedia

History of 401(k) Plans - an article from the Employee Benefit Research Institute (EBRI)

401k Fallout - a 60 Minutes segment

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