The term 401(k) comes from a section of the Internal Revenue Code allowing special tax consideration to help people save for retirement. Americans, particularly “baby boomers,” have relatively low savings rates. The 401(k) plan was created to induce Americans to increase their savings. This plan, along with similar 403b and 457 plans, allows employees to contribute a portion of their salary into a tax-deferred retirement fund. The funds can be invested by the employee in MUTUAL FUNDS, individual stocks, and other INVESTMENT options. A 401(k) plan has a maximum pretax amount that an employee can contribute each year. For 2002 the limit was $11,000, with increases of $1,000 per year allowed through 2006. 401(k) rules also allow a “catch-up” provision of an extra $1,000 for people 50 or older in 2002. This catch-up also increases by $1,000 per year through 2006. Another change made in 2002 eliminated the 25-percent limit to 401(k) contributions. This means anyone can contribute up to $11,000 per year to their 401(k), even if their total INCOME was only $11,000 for the year. (Previously, someone earning $11,000 per year would only be able to contribute 25 percent of the $11,000 to their 401(k).) 401(k) plans offer a variety of benefits. Tax deferment means contributors do not have to pay taxes on their contributions until the funds are withdrawn, usually during retirement. Tax deferment also reduces workers’ current taxable income. In addition, 401(k)s facilitate savings, since the funds are taken out of a worker’s pay. Many companies also match workers’ contributions to 401(k)s, increasing the amount set aside for retirement. In the 1990s, 401(k)s and other defined-contribution RETIREMENT PLANs replaced traditional defined-benefit plans. In a traditional retirement plan, a worker’s retirement pension was a set percentage of their salary, often 50–60 percent of their highest three-year average salary. In defined-contribution plans, employers match employees’ contribution. If an employee elects to contribute 3 percent of their salary, the employer would match that amount. The employee’s retirement pension would be the future value of those funds and would depend on the growth in value of the investments chosen. Employers often put contingencies on their contributions to employees’ 401(k)s—for instance, not allowing employees access to the employers’ contributions until they had been with the company a set amount of time, often 3–5 years (vesting) and making employer contributions in the form of company stock. (Beginning in 2002, the longest a company can require is three years.) These contingencies contributed to the hardship of Enron employees who, in 2001, seeing their 401(k)s “vaporizing,” were unable to sell their Enron stock. Most 401(k) plans allow employees access to funds in an emergency through LOANS or withdrawals. Loans, which are paid back, are not subject to taxes or penalties, but they have their own danger; if an employee leaves or is laid off, he or she will probably have to repay the loan immediately. Withdrawals are restricted by INTERNAL REVENUE SERVICE (IRS) rules and are subject to taxes. The IRS allows withdrawals for
• certain nonreimbursable medical expenses
• purchase of primary residence
• payments for post-secondary education
• to prevent eviction or foreclosure on a home
401(k)s are also portable, meaning they can be carried with an employee when they change employers. When changing jobs employees can
• directly roll an old 401(k) plan into the new employer’s plan
• keep the old 401(k) account and start a new one
• directly roll the old 401(k) into an INDIVIDUAL RETIREMENT ACCOUNT (IRA), and start a new plan with the new employer.