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History of the 401(k)

President George W. Bush signs into law the Pension Protection Act of 2006

Back in 1978, the year of 3 popes, Congress passed the Revenue Act of 1978 which included a provision that became Internal Revenue Code section 401(k).

The 401(k) has roots going back several decades earlier, with many different rulings (Hicks v. US, Revenue Ruling 56-497, and Revenue Ruling 63-180, among others), providing the groundwork for the specialized tax treatment of salary deferrals that Section 401(k) enabled.

More groundwork for the 401(k) as we know it was laid with the passage of the Employee Retirement Income Security Act (ERISA) of 1974, in that the Treasury Department was restricted from putting forth a particular set of regulations that would have reduced or eliminated the tax-deferral benefits of deferred compensation plans. After the Treasury Department withdrew the proposed regulations in 1978, the way was cleared to introduce the 401(k) plan with the Revenue Act.

This particular section of the Code enabled profit-sharing plans to adopt “cash or deferred arrangements”, or CODAs, funded via pre-tax salary deferral contributions. When the 401(k) code section became effective in January 1980, and the IRS proposed the regulations for Section 401(k) in late 1981, the idea came forth to replace existing bonus arrangements with the new tax-deferred alternative.  The real “kicker” that caused the 401(k) plan to garner interest by employers was the ability to save on taxes while still maintaining competitiveness with the earlier bonus plans – and the employer matching arrangement of 401(k) plans did just that.

Several large corporations very quickly began replacing after-tax thrift plans with the new 401(k) plan, and adding 401(k) options to existing profit-sharing and stock bonus plans.  The new 401(k)-type of plan provided the employee with deferred taxation on funds diverted into the plans, and provided the employers with the ability to make significant matching contributions on a tax-favored basis.

In 1984, the Tax Reform Act of ‘84 enacted rules for “non-discrimination” testing in the 401(k) plans – meaning that highly-compensated employees couldn’t receive benefit from the plans if non-highly-compensated employees weren’t participating in the plans to an allowable degree.

Then the 1986 Tax Reform Act further tightened the non-discrimination restrictions and set the maximum annual allowable amount of deferral of compensation by employees at $7,000.  Up to this point, there was only an annual limit on all contributions by both the employer and employee, which was set at $30,000 from 1982 through 2003.  These amounts have gradually increased to today’s levels, of $17,500 for regular deferral by employees and a total annual limit of $51,000.

The 20% mandatory withholding requirement for distributions from 401(k) plans was added with the 1992 Unemployment Compensation Amendments.  This requirement applies to distributions that are not rolled over into another retirement plan.

In 1996, the passage of the Small Business Job Protection Act provided an additional boost to participation in 401(k) plans with the release of limits on the contributions that could be made to a retirement plan by an employee that is also participating in a regular pension, or defined benefit, plan.

One more piece of legislation that had a great impact on 401(k) plans was the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which bumped up the annual maximum contribution by employers and employees (it had been frozen at $30,000 since 1987), as well as adding the “catch-up” contribution provision.  The catch-up contribution provision allows participants who are age 50 or older an additional amount to defer into 401(k) plans annually, not limited by the annual maximum contribution amount.  This was set at $3,000 initially and has been indexed by COLA to the 2013 limit of $5,500.

EGTRRA also introduced the Roth 401(k) feature, which allows participants to elect a designated separate account within the 401(k) plan that accepts salary deferrals on an after-tax basis, and then provides for a Roth-IRA-type of treatment for qualified distributions.

After EGTRRA, the Pension Protection Act of 2006 came along, which made permanent the provisions of EGTRRA (originally these were set to expire in 2010), as well as providing methods for employers to automatically enroll employees in the plans and choose default investments.  The purpose of these provisions was to bolster participation in 401(k) plans and facilitate the best used of these plans.

Most recently, the 2013 American Taxpayer Relief Act (ATRA) provided a method for converting “regular” 401(k) account funds to Roth 401(k) accounts – previously, a participant in a 401(k) plan could only convert funds from a regular account to a Roth account if he or she was in a position to otherwise distributed funds from the account.  Generally this means that the employee/participant has left the job associated with the 401(k) or has reached a retirement age set by the plan administrator.  With the new rules provided by ATRA, these conversions could be undertaken by a currently-employed participant of any age.

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11 Comments

  1. ShirleyNo Gravatar says:

    You guys are all over the place and I cannot seem to connect when I am looking for a reply to my prev question. I am trying to find out if the QCD applies to deferred compensation withdrawals as I have to make distributions from that account and want to apply my JaN 2013 CHARITABLE designation rather than use my other IRA accounts but not sure if I will be able. I also have a managed IRA account and a regular IRA account but I will have to be able to use both funds to reduce my taxable income below the 85,000 amount in order to make it worthwhile. And as I said previously had I known this in 2011 I would have been able to prevent my medicare charges from increasing for this coming year.

    1. jblankenshipNo Gravatar says:

      Shirley,

      My answers to your questions have been consistent.

      As I mentioned in my previous reply to you, the QCD treatment is only available when the distribution is from an IRA, and it cannot come from your deferred comp withdrawal.

      jb

  2. ShirleyNo Gravatar says:

    I cannot locate my prevous comment regarding QCD donations and need to know if the donation is to only one agency or more than one agency and if an agency service multiple services if I can split the donation among more than one service. I want to donate over $6000 but not all to the same agency. I also cannot find where I posted the previous comments/questions and I need an answer before I do one or more QCDs.

    Wish I had seen the below options before I posted the other comments/questions.

    Shirley

  3. ShirleyNo Gravatar says:

    I left a comment/question earlier but cannot find it????? I need to know about the 2012 QCD and whether it can be to multiple agencies/

  4. Steve HollandNo Gravatar says:

    From what I’ve read about the new 401K provisions of ATRA, a sole proprietor with enough income could contribute $51,000 to a non-Roth 401K account throughout the year (including $17,500 in employee deferrals) and then on December 31 do an in-plan rollover of the entire amount. Is that your reading on this? Drilling down further, I guess an in-plan rollover to Roth could be done many times throughout the year the same day that funds go into the non-Roth 401K account.

    If the scenario above is correct, it essentially means all 401K contributions for self-employed individuals up to the $51,000 limit can be turned into Roth contributions in the same calendar year. That’s pretty cool. Is that your reading?

    My understanding that money rolled into a 401K plan from a previous IRA has always been eligible for an in-plan rollover since the Small Business Jobs Act of 2010, regardless of whether the participant otherwise qualifies for a 401K distribution or not.

    On a related topic, I’m of the understanding that for those 401K participants who also qualify for a Deductible Traditional IRA, it’s possible to contribute to the IRA, rollover the money to a 401K non-Roth account, and then do an in-plan rollover to the Roth portion of the 401K all in the same year. Is that your understanding of the rules?

    I’ve read some articles that suggest a contributory Traditional IRA cannot be rolled into a 401K. That doesn’t seem right because if that were the case, it seems the IRS rollover chart at http://bit.ly/rollchart would differentiate on the left between a contributory IRA and a rollover IRA; it does not differentiate. Can contributory IRAs be rolled to a 401K?

    (assuming ‘yes’), If funds in a traditional contributory IRA that were non-deductible are rolled into a 401K, can a participant then do an in-plan rollover of those funds to a designated Roth account in the same plan and pay no tax on the conversion of the contributed non-deductible funds? Are there no restrictions that parallel the ones of converting a traditional IRA to a Roth IRA as discussed in this article – http://bit.ly/backdoorrothproblems?

    1. jblankenshipNo Gravatar says:

      These are some very good questions Steve. You’ve definitely done your homework!

      The fly in the ointment is that only traditional “pre-tax” or deducted IRA money can be rolled into a 401(k) plan. Non-deductible IRA contributions are not allowed to be rolled into a 401(k) plan, only those amounts that are yet to be taxed.

      The strategy that you’ve listed could be utilized, just a bit different set of actions: non-deductible IRA contributions could be made in the year, and all other IRA balances could be moved into the 401(k) plan. Then all you have remaining in IRAs is the non-deductible contributions, which could be converted to Roth IRA. If you choose to do so, you could also then convert your 401(k) balance to Roth 401(k) – although this is taking more steps than necessary. You could have just converted all IRA funds (deductible, growth, and non-deductible) to a Roth IRA and you’ve accomplished the same thing, with the same tax effect.

      Otherwise, what you’ve described is all allowable.

      jb

      1. Steve HollandNo Gravatar says:

        JB,
        Thanks for your reply. I didn’t know that non-deductible IRAs cannot be rolled to a 401K. I’m surprised that the IRS rollover chart that I linked to does not make that clear. Do you know what part of the tax code that prohibition comes from?

        Very interesting strategy that you laid out. For many people it may accomplish what they want to achieve. I’m trying to get/keep all my retirement plan assets in my Solo 401K because of the advantages it offers for self-directed investing (i.e. real estate) including no custodian required and no UDFI on debt-financed properties. So the scenario you laid out is not quite as good for me but helpful to know.

        Great to hear that my assessment in the first two paragraphs is right with regard to the new 401K rules contained in ATRA. Now they should just simplify all the paperwork and allow Roth type employer contributions directly!

        Thanks again for your insights.

        1. jblankenshipNo Gravatar says:

          Steve,
          No, I don’t offhand know what part of the tax code it comes from. There has always been a qualifier on “roll-in” transfers – that the money being transferred must otherwise be subject to tax if distributed. That prohibits after-tax (non-deductible) contributions from being rolled in to 401(k) plans (and other QRPs).

          jb

          1. Steve HollandNo Gravatar says:

            That explanation helps me make sense of it. I bet it is the same section of the code that prohibits the rollover of Roth IRA money to a designated Roth account of a 401K. I was told that is Section 402(c)(2).

            Just to clarify from my original post, is it your understanding that deductible, contributory IRAs CAN be rolled into a 401K?

          2. jblankenshipNo Gravatar says:

            Yes, funds from an IRA that would otherwise be taxable if distributed can be eligible to rollover into a 401(k), subject to the plan administrator rules (it’s not required to be allowed). Since you have a solo(k), you shouldn’t get an argument from your administrator.

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