Before the creation of 401(k)s, companies allowed employees who received bonuses and other profit-sharing compensation to defer payment, effectively deferring payment of taxes on the income. While this practice sounds similar to that of today's 401(k)s, it was informal and typically an option only for highly paid employees.
The IRS thought the deferred arrangement favored highly paid employees too much and added section "k" in 1978. It added a nondiscrimination "test" that tied the maximum deferrals made by highly paid employees to the amount lesser-paid employees chose to defer. Section 401(k) was added to the IRS code to settle tax equality questions.
While on vacation in 1980, R. Theodore Benna, an employee benefits consultant in Philadelphia, read and reread the new section of code and envisioned the new legislation completely differently from what the IRS had intended.
Benna realized that, while not the object, Section 401(k) codified the common practice of deferring compensation. It allowed employees to make decisions about participation and contribution levels.
Not only could employees choose to participate in some form of tax-deferred savings, but employers could match employee contributions. Benna saw the potentially huge impact of a formalized employee tax-deferred savings plan, especially one that incorporated matching contributions.
He established the first 401(k) plan in 1981 for his company, spawning one of the best-known and used employee retirement savings devices. The plan helped his company lower its tax bills and encouraged all employees, not just the highly paid, to save.
By 1985, the 401(k) was very popular -- perhaps too popular for some lawmakers. The U.S. Treasury estimated it had lost $10 billion in tax revenue since 1981 due to tax-deferred contributions. Alarmed, it approached Congress to end the revenue drain by changing the law. Benna launched a massive letter-writing campaign and succeeded in retaining the 401(k), although Congress significantly reduced the maximum deferral.
As Benna later realized, the biggest challenge to use of 401(k) plans was a lack of understanding about investing. Markets fluctuate, and education is critical to prepare people to tolerate short-term losses and make commitments to savings and investing for long-term gains.
Today, employers have a fiduciary responsibility to help prepare employees to make reasonable investment decisions for long-term planning. Since many don't have the expertise or resources to educate employees about savings options, it is important to ask a financial expert to help.
Consult a financial adviser who can work with employers of all disciplines and sizes to serve as an education consultant. Whether a company has a new plan or one with millions of dollars in assets, it's a good idea to re-evaluate it and the education component, and to help employees reap the rewards of balanced long-term financial planning. How to reach: Roger St. Cyr, vice president and senior consultant, Fifth Third Bank Investment Advisors, (614) 341-2606 or Roger.St.Cyr@53.com