Why Is It Called a 401(k)?

The term “401(k)” comes from the section of the U.S. Internal Revenue Code that established this retirement savings plan. Introduced in 1978, Section 401(k) allows employees to defer a portion of their salary into individual accounts, which can be invested in various financial products. This tax-advantaged retirement plan gained popularity because it provides employees with a convenient and efficient way to save for their future, offering potential tax benefits and employer matching contributions. A financial advisor can also help you with retirement planning with a 401(k) or IRA.

The History Behind the 401(k)

A 401(k) is a retirement savings plan offered by employers. It allows employees to contribute a portion of their salary on a pre-tax or post-tax basis, often with employer matching contributions.

Before 401(k)s became a mainstream feature for many Americans, workers often relied on defined-benefit pension plans, which promised specific monthly retirement benefits that were calculated based on factors such as salary history and duration of employment.

Rising costs and financial instability drove companies to look for more sustainable solutions. In 1978, Congress enacted the Revenue Act, which included this provision that allowed employees to defer a portion of their salary into a tax-advantaged retirement account.

The ability to defer taxes on contributions until withdrawal made 401(k) plans particularly appealing, leading to a fundamental change in the landscape of retirement planning in the U.S.

Pensions eventually were largely replaced with 401(k) plans because 401(k)s reduced employer costs and liabilities, and shifted investment risk to employees while offering greater portability and flexibility. By the mid-1980s, many companies were offering 401(k) plans, and millions of Americans were contributing to their retirement savings.

Over the years, legislative changes have enhanced 401(k) plans. The Economic Growth and Tax Relief Reconciliation Act of 2001, for example, increased contribution limits and introduced “catch-up” contributions for those over 50, encouraging even greater participation. As a result, these changes, coupled with the stock market’s potential for growth, have made 401(k) plans a powerful tool for building retirement wealth.

How 401(k)s Work

A woman calculating how much she should save for her 401(k) plan.

A 401(k) plan offers several advantages, including tax benefits. Contributions to traditional 401(k) plans are made with pre-tax dollars, which reduces your taxable income for the year. Roth 401(k) plans, on the other hand, allow you to make post-tax contributions but withdrawals are generally not taxed. Employers often match a portion of employee contributions, effectively giving you free money for retirement.

Once funds are in your 401(k) account, they can be invested in various options such as stocks, bonds and mutual funds. If you have a traditional 401(k), the growth of your investments is tax-deferred, meaning you won’t pay taxes on the earnings until you withdraw the money. This tax deferral allows your investments to compound more quickly than they would in a taxable account, potentially leading to greater long-term growth.

Funds withdrawn before age 59½ are typically subject to a 10% early withdrawal penalty in addition to regular income taxes. However, there are exceptions for specific circumstances like significant medical expenses or disability. After age 59½, you can withdraw from your 401(k) without penalty, but the funds are still subject to income tax.

Once you reach age 73, the IRS mandates that you begin taking required minimum distributions (RMDs) from your 401(k). The amount of these distributions is based on your life expectancy and account balance. Failure to take RMDs can result in hefty penalties, so it’s important to understand and plan for these withdrawals.

401(k) Contribution Limits

In 2024, the IRS allows individuals to contribute up to $23,000 if they are under 50. For those aged 50 and above, an additional catch-up contribution of $7,500 is permitted, bringing the total to $30,500. These limits are periodically adjusted for inflation.

Maximizing your 401(k) contributions can significantly impact your retirement savings. Employers often match a portion of your contributions, which is essentially free money. By contributing the maximum allowed, you not only benefit from the tax advantages, but also from compounded growth over time.

Comparing 401(k)s Against Other Retirement Accounts

An individual retirement account (IRA) is another popular retirement savings option. Unlike a 401(k), IRAs are not employer-sponsored, giving individuals more flexibility in their investment choices. Contributions to a traditional IRA may be tax-deductible, and the investments grow tax-deferred, similar to a 401(k). However, the contribution limits for IRAs are generally lower than those for 401(k)s, potentially limiting how much you can save annually.

A Roth IRA offers a different tax advantage. Contributions to a Roth IRA are made with after-tax dollars, meaning you don’t get a tax deduction upfront. However, the investments grow tax-free, and qualified withdrawals in retirement are also tax-free. This can be a significant benefit if you expect to be in a higher tax bracket in retirement. Roth IRAs also offer more flexibility with withdrawals, as contributions (but not earnings) can be withdrawn at any time without penalty.

When comparing 401(k)s to Roth IRAs and traditional IRAs, it’s essential to consider contribution limits and withdrawal rules. In 2024, the contribution limit for a 401(k) is $23,000, with an additional $7,500 catch-up contribution for those aged 50 and older.

In contrast, the contribution limit for IRAs (both traditional and Roth) is $7,000, with a $1,000 catch-up contribution. While 401(k) contributions reduce taxable income immediately, Roth IRA contributions provide tax-free withdrawals, which can be advantageous in retirement.

Another critical comparison point is the range of investment choices and associated fees. 401(k) plans are limited to the investment options provided by the employer’s plan, which can sometimes be restrictive and come with higher fees. In contrast, IRAs and Roth IRAs typically offer a broader range of investment options, including individual stocks, bonds and mutual funds, often with lower fees.

Bottom Line

A woman determining how much she should save for retirement.

Section 401(k) was enacted into law in 1978, leading to the 401(k) plans we know today. This law allowed employees to defer a portion of their salary into a retirement account without being taxed until the money is withdrawn. This innovative approach to retirement savings provided a tax-advantaged way for workers to build their nest eggs. Over time, 401(k) plans have become a staple of American retirement planning, offering a flexible and powerful tool for financial growth.

Tips for Investing in a 401(k)

Wondering if you’re contributing enough to your 401(k)? There are rules of thumb you can use to see if you’re on track, but a financial advisor can take your personal situation into account and help you stay on course. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
A 401(k) isn’t an investment itself but an account that holds investments. Beyond contributing to a 401(k), you have to create an asset allocation that aligns with your age, risk tolerance and goals. If you’re a beginning investor, review how to allocate your portfolio’s asset allocation to ensure you’re on track to reach your retirement goals.