How would you like a pay raise without asking your boss for a raise? Prior to the 1980s, if you worked for a company, your company likely paid into a defined pension plan for you. This worked well since this offered a fixed amount of income from the time you retired until you passed away. It may also have provided a regular fixed amount for a widow or widower after the worker passed away. Some of you may still have a pension, but that is quickly becoming a thing of the past.
Since the 1980s, if you work for one of the 94% of companies that provide a retirement account with matching funds, you may already have that raise sitting there waiting for you! The retirement account is called a 401K (403b for those in education or non-profits), named after the section of the Internal Revenue rules that define them. Your pay raise comes in the form of matching funds.
How Did the 401(K) Plan Come About?
In 1978, Congress passed the Revenue Act of 1978 that included a modification of the tax code that allowed executives to be able to defer taxes on compensation from bonuses or stock options. Ted Benna, a consultant, saw this as an opportunity to allow not just executives but all employees to be able to defer taxes on some of their income through salary deductions to a savings account that the company would create. It was an accidental side-effect of this executive perk.
You Get a Pay Raise, and You Get a Pay Raise, Everyone Gets a Pay Raise!
Soon after, companies saw that instead of contributing toward a retirement plan, they could offer the employee that same amount of cash that they could then put into that tax-deferred savings account. In many cases, the companies offered an incentive to employees to use this plan by matching funds that the employee chose to contribute. And voila, a secret pay raise as long as the employee contributes!
How Does a 401(K) work?
Once you sign up to participate, you define a certain percentage of your pre-tax income that you want to have put into the 401K plan. Often, an employer will match up to a certain percentage, so if possible, take advantage of this and choose an amount at least equal to the amount the employer will match.
As an example, if your employer will match 50 cents for every dollar you save up to 6% of your salary, then choose to have 6% of your income saved into the 401K. Your employer will kick in 3% which is like a quick 3% salary increase! Surprisingly, a lot of people don’t take advantage of this. If you’ve felt this 401(k) plan concept was too complicated and so didn’t sign up for it, now is the time to take advantage of your “free pay raise” and sign up.
What Has Changed About Participation Rates?
When 401(k) plans started, not many employees took advantage of these plans. They were optional and the employee had to initiate the process. I was the typical employee when I started first job out of school. I had all of this paperwork to go through as part of the onboarding process, and since the 401(k) paperwork wasn’t required, I set it aside and didn’t get back to it. Since I was pretty typical, the result was a very low participation rate.
In 2006, the Pension Protection Act required companies to be more fiscally responsible for their employees. Without getting into the details, it became easier for companies to meet some of the requirements of the Act by setting up an automatic opt-in for the 401(k) plan for all employees. It also required the companies to offer an “appropriate” investment option to invest these funds. The result is that most companies now automatically enroll employees into their 401(k) plan, as well as often investing that money into a “Target Retirement Fund”. If you want to opt-out, or you want a different investment for the account, then you have to take action to change the defaults.
The Dark Side of the 401(k) Retirement Plan
The change from the defined pension plan to the 401(k) plan resulted in a shift that turned out not to be in most employee’s interest. When pension plans were the retirement method, the money in this plan was invested by the company so that they had enough funds for every employee who retired to receive their full amount. The onus was on the company to invest the funds well.
With the 401(k) plan, the company provided a range of ways to invest the funds, but it was the responsibility of the employee to choose how that money was invested. Since most employees were not financial experts, much less investment experts, it put a burden on employees that had huge retirement implications. A wrong investment decision might make the difference between having enough and not having enough money available at retirement! No pressure!
The Rise of the Retirement Planner
To help people with making those retirement investing decisions, a whole industry of retirement planners has grown up. But not everyone takes advantage of these experts. In addition, your company may provide access to retirement planning services as part of your benefits. If so, take advantage of this service to make good initial investing decisions, as well as reviewing it on a regular basis.
There is a lot more to say about 401K programs, and an independent financial advisor or your company’s benefits advisor can give you all the details of your particular plan. Regardless of the plan, there are a number of benefits of putting savings into a 401K:
- The money goes in as pre-tax money so you don’t have to pay taxes on the money you save (until you take it out when you retire). That helps save on your taxes now. This means that if you put $100 into the plan each pay period, your take-home pay won’t be $100 less.
- The money gets taken out before you get paid, so you’ll likely never miss it and is an easy way to not have to think about saving.
- Over long periods of time (30+ years), the concept of compounding of interest can increase the value to several multiples of what you put in.