Definition: Accounts that take advantage of a provision of the U.S. tax code that allows privatesector employees to make pretax contributions to employer-sponsored retirement plans
Significance: Most businesses with pension plans have replaced traditional defined-benefit plans with 401(k) retirement plans, or what are classified as defined-contribution pension plans. They have thus become the primary method whereby private-sector employees save for retirement.
Section 401(k) of the U.S. Internal Revenue Code was created by the Revenue Act of 1978. The law went into effect on January 1, 1980, and after the Internal Revenue Service (IRS) issued formal rules regarding 401(k) retirement plans in November, 1981, these plans quickly became the fastest growing type of employer-sponsored retirement plans. By the year 2000, more than 50 percent of privatesector employees with employer-sponsored retirement plans had 401(k) plans.
Section 401(k) of the tax code outlines a method for private-sector employees to save for retirement. It allows for employees to contribute a portion of their income into investment options available from an employer-sponsored plan. In addition to the employee’s contribution, many employers also make contributions of cash or company stock. As long as the employee remains in the plan, these contributions, and the subsequent investment gains, are not subject to income tax. Taxes are paid when the funds are withdrawn during retirement years. To discourage the withdrawal of funds before retirement, amounts withdrawn before the employee reaches the age of 591⁄2 are subject to a 10 percent penalty in addition to the payment of income tax. There are, however, provisions that allow individuals to borrow money from their plans before retirement or to withdraw specific amounts to pay for the purchase of a first home.
The rapid growth of 401(k) plans is attributable to features of the plans that appeal to both employees and employers. Not only do contributions to these plans reduce taxes during working years, but 401(k) plans also are portable, which means that employees can roll the money into another employer’s 401(k) plan or an individual retirement account (IRA) if they move from one job to another before retirement. A benefit to employers is the ability to offer employees a retirement plan that avoids the risks employers face with a traditional pension plan. The risks associated with investment losses are borne by employees under 401(k) plans.
Unlike traditional pension plans, which provide a fixed income to retired employees, 401(k) plans offer no guarantee regarding the amount of retirement income, which may fluctuate along with financial markets. Thus, although these plans offer a means to retain retirement savings for job changers, they can make retirement planning more challenging for employees. The attraction for employers in shifting the risks associated with traditional retirement plans to employees and the appeal of portability for employees have caused 401(k) retirement plans to supplant traditional retirement plans for a majority of private-sector employers.

Further Reading
Munnell, Alica H., and Annika Sundén. Coming Up Short: The Challenge of 401(k) Plans. Washington, D.C.: Brookings Institution Press, 2004.
Wise, David A., ed. Perspectives on the Economics of Aging. Chicago: University of Chicago Press, 2004.
Wolman, William, and Anne Colamosca. The Great 401(k) Hoax. Cambridge, Mass.: Perseus Books, 2002.
See also: bond industry; Funeral industry; Mutual fund industry; Pension and retirement plans; Social Security system; stock markets; Taxation.