Before 1978, most retirement plans were set up as pensions. Although the term “pension” can colloquially refer to any kind of retirement account, usually what is meant by “pension” is a defined-benefit plan. “Defined-benefit plan” is a technical term for a retirement plan where an employer guarantees payment of a certain amount when you retire based on how long you worked at the company and what your salary was at that job. With pensions, the burden of risk in setting you up for retirement was entirely on your employer because they were required to pay you an agreed-upon amount at retirement regardless of the pension fund’s return.
So, what changed in 1978? Congress passed the Revenue Act of 1978. This act added a provision to the Internal Revenue Code called “401(k).” This provision added a new tax-advantaged way for employees to defer a percentage of their compensation to avoid taxation. The name of that provision is actually the origin of the term “401(k).” After the introduction of the Revenue Act of 1978, a benefits consultant named Ted Benna developed a retirement plan based on that 401(k) provision. After a few years, many major companies were offering 401(k) plans, and the 401(k) took off as one of the most popular retirement plans in the country, replacing pensions and altering the retirement landscape.
So, what’s different with a 401(k)? A 401(k) is what’s called a defined-contribution plan. This kind of account is primarily employee-funded, although it is possible for employers to make contributions to these kinds of accounts as well. The employee is not guaranteed a specific payment on retirement–rather, they are allowed to set up an investment account themselves which has a tax-advantaged status that they are allowed to access when they reach 59 ½ (and in some cases, 55).
Regardless of what kind of accounts you have, it’s not always clear how best to use them to maximize your retirement. If you’re curious about what a financial professional can do for you, reach out to us today for a complimentary review of your unique financial situation.
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