401k – The Accidental Savings Plan

Do you ever wonder what may be buried in the 40,000 new laws that were passed last year? Frequently, a few sentences that did not seem to be a big deal at the time turn out to have huge impacts on people’s lives. One example was a minor change to the IRS tax code in 1978, that actually turned into today’s well known 401k plan. The language was intended to clear up some uncertainty about the preferential tax status of profit-sharing plans, which had existed for several decades. This was a minor item, intended to cover a handful of companies that used such plans.

Unintended consequences:

Someone soon realized that the provisions of Section 401(k), which facilitated employees choosing whether to receive profit sharing from an employer as either a cash bonus or a contribution to a retirement plan, could actually be used to allow employees to deduct money from each paycheck into a tax-deferred retirement plan, “regardless of whether the firm turned a profit.” Fast forward 37 years and the 401k plan has become a predominant retirement saving vehicle for 100 million employees, holding close to $7 trillion. The tax cost to the treasury, which was originally expected to be immaterial, is now over $57 billion per year.

Lawmakers also never intended to kill off corporate pensions. Nevertheless, as 401k plans proliferated, more and more companies dropped their pensions. The number of pensions fell from 170,000 plans in 1985 to less than 40,000 plans today. Congress would have structured 401ks a little bit differently if it had known that those few sentences in an obscure IRS bill in 1978 were going to become the cornerstone of retirement savings. Some features such as auto enrollment, default investment options, and limits on fees are just now becoming common.

Here are a few thoughts and recommendations on 401ks (and the very similar 403b):

1)  The 401k should be the first place most employees save. The automatic deduction from an employee’s paycheck makes a huge difference. Savings that are loosely budgeted but not automatically deducted from your paycheck frequently get spent on “emergencies”…like holiday presents.

2)  Employees should save at least 10% of their gross pay per year, and more if they can. If employees cannot save 10%, they should always contribute at least up to the amount that a company matches. An employee in the 25% tax bracket could take home $.75 after taxes or put the full $1.00 in their 401k. If the company offers a 50% match, then the tradeoff is $.75 to spend today or $1.50 saved for retirement. From my experience, most “millionaire next door” types make their money by systematically contributing the maximum to their company retirement plans.

3)  Borrowing from your 401k is not recommended. Approximately 87% of 401k plans allow loans, which are limited to the lesser of $50,000 or 50% of your account balance. You must repay a loan on a systematic schedule with payments at least quarterly. The loan will become taxable as ordinary income, plus a 10% penalty if you’re under 59 ½, if you neglect to make a payment for more than 90 days. Another wrinkle is you must repay the entire loan within 60 days or incur those same financial penalties, if you leave your job or are let go.

4)  Rollovers: once you have built up a substantial balance in your 401k, you may decide that an IRA would offer better investment choices, lower expenses, or guarantees (in the form of IRA annuities). Ask your 401k plan administrator whether the plan allows “partial in-service rollovers.” These allow you to transfer your money to an IRA where you can place your funds in almost any investment and possibly reduce your fees.

Final thought: All principles of investing apply to 401ks (diversification, risk tolerance, time-horizon, etc.). That being said, do not over-think it. Just sock way as much as you can and don’t try to time the market. No one ever says, “I wish I saved less or speculated more.”