How do you really feel about 401k plans?

Prior to ERISA, there were many non-qualified deferred compensation profit sharing plans. Few lower paid workers deferred the “bonus”. A much larger percentage of higher paid workers deferred the “bonus”. As a result, these plans were highly discriminatory in operation. They also had a noticeable impact on federal budget revenues.

It wasn’t clear how to address these programs as part of ERISA. So, Congress specifically decided to exclude these plans from ERISA to give it time to study.

When Congress added 401k to the code as part of the Revenue Act of 1978, they tied deferrals to passing non-discrimination tests for the very first time. They believed such rules would actually curtail deferral activity where it was offered to a broad cross section of workers. And, per the joint tax committee analysis, it was scored as having a negligible effect on budget receipts.

The Congressional summary https://www.congress.gov/bill/95th-congress/house-bill/13511 states it as:

“Excludes from the gross income of an eligible employee, contributions by an employer to a qualified employee pension trust, even if the trust plan permits the employee to take the employer contribution in cash or have it paid to the trust.”

In other words, this is where the concept of employee deferrals are treated as employer contributions.

In the same legislation, we got IRC 125 cafeteria plan changes, which was also scored by the JTC as having minimal impact on federal revenues. That is, Congress decided to look at cash or deferal, pre-tax contributions on the same basis as non-elective employer contribution.

I became “expert” on this when I joined the Plan Sponsor Council of America in 2017. PSCA dates back to 1947 when it was organized as Council of Profit Sharing Industries, later named the Profit Sharing Council of America, later the Profit Sharing/401k Council of America, and finally the Plan sponsor Council of America (where profit sharing was often organized with a cash or deferred option).

From EBRI: https://www.ebri.org/docs/default-source/fast-facts/ff-318-k-40year-5nov18.pdf?ref=guideline.com

“… Pre-1978— Deferred compensation arrangements (“cash or deferred arrangements,” known as CODAs), which allowed some compensation (and resulting tax liability) to be deferred, predate 401(k) plans by several decades and are viewed as their precursors. An ongoing debate between employers and the Internal Revenue Service (IRS) about the extent of restrictions on such plans culminated in IRS guidance in 1956 (Rev. Rul, 56−497), which was revised as Rev. Rul. 63−180 seven years later in response to a federal court ruling (Hicks v. U.S.) on the deferral of profit-sharing contributions.

The Employee Retirement Income Security Act of 1974 (ERISA) barred the issuance of Treasury regulations prior to 1977 that would impact plans in place on June 27, 1974, thereby freezing a regulation proposed by the IRS in December 1972 that would have severely restricted the tax-deferred status of such plans. This action inhibited the creation of some new plans. After Congress extended the moratorium deadline twice, the IRS withdrew the proposed regulation in 1978. ERISA also mandated a study of salary reduction plans that influenced 1978 legislation creating 401(k) plans.

1978— The Revenue Act of 1978 included a provision that became Internal Revenue Code (IRC) Sec. 401(k) (for which the plans are named), under which employees are not taxed on the portion of income they elect to receive as deferred compensation rather than as direct cash payments. The Revenue Act of 1978 added permanent provisions to the IRC sanctioning the use of salary reductions as a source of plan contributions. The law went into effect on Jan. 1, 1980. Regulations were issued in November of 1981. …”

See: https://www.jct.gov/publications/1979/jcs-7-79/

Certain Cash or Deferred Arrangements (sec. 135 of the Act and new sees. 401(k) and 402(a)(8) of the Code)

Prior law

The benefits or contributions under a tax-qualified plan must not discriminate in favor of employees who are officers, shar~holders, or highly compensated, and the p}an must meet stlandards designed to assure that the classification of employees covered by the plan is not discriminatory. In the case of a tax-qualified cash or deferred profit·· sharing plan, the employer gives an employee the choice of (1) being paid ‘a specified ‘amount in cash as current compensation, or (2) having that amount contributed to the plan. Rev. Rul. 56-497, 1956-2 C.B. 284, upheld the tax-qualified status of a cash or deferred profit-sharing plan where, in operation, over one-half of the employees who elected profit-sharing contributions (deferral), rather than current compensation, were ‘among the lowest paid two-thirds of the employees who had met the plan’s 3-year eligibility requirement. (See also Rev. Rul. 63-180, 1963-2 C.B. 189, and Rev. Rul. 68-89, 1968-1 C.B. 402.)

On December 6, 1972, the Internal Revenue ‘Service issued proposed regulations which called into question the tax treatment of employees covered by cash or deferred profit-sharing plans. These proposed regulations were withdrawn in .July, 1978. Under the rules in effect at the time of the proposal, an employee was not taxed currently on amounts he chose to have contributed to a tax-qualified cash or deferred profitsharing plan.

In order to ‘allow time for Congressional study of this area, section 2006 of the Employee Retirement Income Security Act of 1974 (ERISA) provided for a temporary freeze of the status quo. Under ERISA. the tax treatment of contributions to cash or deferred profitsharing plans in existence on June 27, 1974, was governed under the law as it was applied prior to January 1, 1972,1 ‘and this treatment was to continue at least through De.cember 31, 1976, or (if later) until regulations were issued in final form in this area, which would change the pre-1972 administration of the law.

In the case of plans not in existence on June 27, 1974, contributions to ‘a cash or deferred profit-sharing plan were treated as employee contributions (until January 1, 19’77, or until new regulrutions were prescribed in this area). This was intended to prevent a situation where ‘a new plan might begin in reliance on pre-1972 law before Congress determined what the law should be in the future.

The Tax Reform Act of 1976 (sec. 1506) extended the temporary freeze of the status quo until January 1, 1978, in order to allow addi-tional time for Congressional study of this area. The Foreign Earned Income Act of 1978 (P.L. 95-615) extended these rules until the related provisions of the Revenue Act of 1978 are effective (i.e., it extended the treatment through 1979) .

Reasons for change
Since the enactment of ERISA, the freeze of the status quo treatment of cash or deferred profit-sharing plans has prevented employers from setting up new plans of this type for their employees. Originally, it was thought that a relatively short period of time would be needed
for Congressional study and that a permanent solution ‘Would be in place by January 1, 1977. The Congress concluded that the uncertainty caused by the state of the law had created the need for ‘a permanent solution which would permit employers to establish new cash or
deferred arrangements. Also, the Congress believed that prior law discriminated against employers who had not established such arrangements by June 27, 1974.

Explanation of provision
The Act adds new provisions to the Code (sees. 401(k) and 402 (a) (8) to permit employers to establish tax-qualified cash or deferredprofit-sharing plans (or stock bonus plans) . In addition, it provides a transitional rule to permit plans in existence on June 27, 1974 to rely on certain pre-1972 revenue rulings until plan years beginning in 1980.

The Act provides that a participant in a qualified cash or deferred arrangment will not have to include in income any employer contribution to the plan merely because he could have elected to receive such amount in cash instead. For the cash or deferred arrangement to be a tax-qualified plan, it must satisfy the usual profit-sharing or stock bonus plan qualification rules. In addition, it must satisfy the following requirements: (1) it must not permit the distribution of amounts attributable to employer contributions merely because of the completion of a stated period of plan participation or the passage of a fixed period of time (unlike profit-sharing plans in general, where distributions may be made in the third calendar year following the calendar
year of the employer’s contribution), and (2) all amounts contributed by the employer pursuant to an employee’s election must be nonforfeitable at all times.

Special nondiscrimination rules are provided for these arrangements in lieu of the usual rules for testing discrimination in contributions to the plan. A cash or deferred arrangement will meet these nondiscrimination requirements for qualification for a plan year if (1) the actual deferral percentage 2 for the highest paid one-third of all participants does not exceed the deferral percentage for the other eligible employees by more than 50 percent, or (2) the actual
deferral percentage for the highest paid one-third of all participants does not exceed the actual deferral percentage of the other eligible employees by more than three percentage points. (If this latter test is used, the actual deferral percentage for the highest paid one-third cannot
exceed the actual deferral percentage of all other eligible employees by more than 150 percent. In determining the highest paid one-third of all participants, only amounts considered as compensation under the provisions of the plan are taken into account. Therefore, the plan
will have to have participation by employees in the lower paid group in order to obtain any deferral for the highest paid one-third.

Effective date
This provision is effective for taxable years .beginning after December 31, 1979; however, a transitional rule is provided for those cash or deferred arrangements in existence on June 27, 1974, under which their qualified status for plan years beginning before January 1,
1980 will be determined in a manner consistent with Rev. Rul. 56-497 (1956-2 C.B. 284), Rev. Rul. 63-180 (1963-2 C.B. 189), and Rev. Rul. 68-89 (1968-1 C.B. 402)

Revenue effect
This provision will have a negligible effect upon budget receipts

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“How does all that wealth benefit the lower 50% of income Americans?”

Agree, that for the 40% of households who do not pay any income taxes, deferring monies to a 401k plan makes little sense. These are the same individuals, however, who disproportionately benefit from all of the health and welfare, and entitlement programs. The lowest income Americans can get as much as 90% replacement of their average wages from Social Security.

How does stock market risk affect retirement security?

Historically, it actually improves retirement security throughout the accumulation period. Participants have to consider both the potential loss of principal, and loss of purchasing power. Post retirement, it generally is as effective as any other investment when hedging for inflation. For me, I would also want to consider spending assets to bridge deferral of Social Security to Full Retirement Age or even Age 70 – as only SS provides a guaranteed, inflation-indexed income, with superior surviving spouse benefits.

How is that wealth handled by the significant percentage of Americans deficient in financial literacy?

Definitely could be better. But better to have saved and handled/spent poorly, than never to have saved at all.

A great wealth builder for some for sure, a great vehicle for retirement for a big portion of society? Questionable.

Disagree, again, we now have over 700,000 401k plans, 100+ million accounts, and over their lifetime, over $20 Trillion has passed through or remains in 401k plans – between start in 1981 and today. Plan assets totaled $91 Billion in 1984, $7.9 Trillion in 2023. If history repeats itself over the next 40 years as occurred during the prior 40 years, with the same 12.1% per year growth net of leakage/withdrawals (NOT GOING TO HAPPEN), that would grow to $172 Trillion dollars in 2050, $761 Trillion in 2063!

Show me a better wealth builder! More importantly, the 401k is in addition to (not in lieu of) other wealth builders (IRAs, home equity, life insurance, brokerage accounts, etc.)

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