What Is a 401(k)?

The benefits of 401k plan

A 401(k) is a kind of retirement fund. The strange name comes from the section of the US Internal Revenue Code that determines the 401(k)’s tax benefits. It’s use a retirement fund was unintended.

In 1978, Congress passed a Revenue Act that included a section enabling employees to defer tax on deferred compensation. Section 401(k) meant that if a company agreed to pay an employee a sum of money but would only give that amount to the employee in the future, the employee wouldn’t be liable for tax on that amount until they received it.

It took a couple of years before benefits consultant Ted Benna saw the opportunity to use the section to create a tax-friendly retirement program for a client. Employees would put money into a fund, and receive a matching amount from the client. Because the employer’s contribution was deferred, the employee wouldn’t have to pay tax on it until they made a withdrawal from the fund.

The client wasn’t crazy about the idea but Benna’s firm, The Johnson Companies, used the system to create its own pension plan. This is similar to an annuity plan.

A year later, the IRS made the idea official by issuing new rules. Employees could now fund their 401(k) directly from payroll deductions. In effect, they could receive a tax deferment on both their own contributions and the employer contributions. By 1983, almost half of all large companies had either implemented a 401(k) plan or were thinking about it.