History of pensions and 401Ks - Pensions became a common benefit to reduce hiring costs and encourage employees to stay with their company for the entirety of their lives. Pensions were became a common benefit and were guaranteed for life.
Traditional pension plans are called “defined benefit plans”. These plans were solely funded by the employers. This was based on how much they earned, how long they worked, and other criteria. They were promised a set benefit for life when their employees retired.
Eventually the cost outweighed the benefit. Many companies began opting out of pension plans and started choosing defined contribution plans (401k) or went out of business. People were losing their pensions when the companies they once worked for went out of business or was replaced by 401(k)s.
Pensions are rare today but can still be found in some industries like education, government jobs, health care, and in a few corporations.
In 1974 President Ford signed into law the Employee Retirement Income Security Act (ERISA). ERISA set minimum standards for private pension plans and set up the Pension Benefit Guaranty Corporation, which insures pensions. This was done to safeguard pensions.
The closest things we have to a pension plan today are Social Security and annuities. Due.com has lots of detailed information on pension plans and 401k’s: https://due.com/pension/the-history-of-the-pension-plan/
The birth of 401K’s
The 401(k) got its start when the Revenue Act of 1978 amended the Internal Revenue Code. It allowed for a reduction in taxes for individuals as well as estates and trusts.
Ted Benna was the person responsible for the creation of the 401k and known as the father of the 401k. Benna never thought 401k’s would replace pension plans and regrets that decision.
Benna designed a way to use this Act allowing employees to contribute part of their pay before taxes and let it grow tax-deferred. On the flip side, employers could also reduce their tax liabilities.
Employers found that 401(k) plans were much more affordable. No longer was the employer solely responsible for funding the entire retirement plan. This new option allowed employers to fund a portion or match the employee contribution without having to pay for the life of the plan.
With 401k’s, employees are left with the responsibility to invest in their retirement with little to no experience of how to invest. Employees are usually given a list of packages that they can choose from.
With 401k the investments rise and fall with the market and can be depleted.
All 401(k)s are known as “defined contribution plans”. Unlike pension plans, they are funded by employees. However, they can also be funded by employers.
How much the employee and/or the employer contribute and how well their investments do over the years determine how much money would be available for retirement.
5 Types of 401K plans exist
There are many kinds of 401(k) plans. Below is a list in order of what is the most common to the least common:
1. Traditional 401(k)
This is the most common of the 401(k)s and they are tax-deferred. The money is deducted prior to taxes. Contributions to the 401(k) are made by the employee each pay period and are usually deducted through their payroll.
Different 401(k) packages are offered to the employee. The employee chooses a package based on their risk tolerance. Most of the time these investments consist of mutual funds.
Holders won’t have to pay taxes on this money until they withdraw it, usually in retirement.
401(k) Contributions
The maximum an employee can contribute to their 401(k) is determined by the IRS. Since the cost of living increases each year, there is also an increase in the contribution allowed. For 2026 the limit is $24,500. The limits are updated every year on the IRS website https://www.irs.gov, and you can search there for “contribution limits” to find the latest.
Employers can also make matching contributions. Each employer is different so you would have to check how much your employer contributes. Those 50 and older can contribute more, known as “catch-up contributions”: an extra $8,000 for 2026, or $11,250 if you are 60 to 63.
Withdrawals, Penalties, and Exceptions
Upon retirement, withdrawals from this account are taxed as ordinary income. Anything withdrawn prior to age 59 1/2 could be subject to a 10% penalty. There are some exceptions where you won’t be penalized:
- disability
- leaving your job in or after the year you turn 55 (the “rule of 55”), for the 401(k) at the employer you left
- unreimbursed medical bills above 7.5% of your income
- the death of the account holder to beneficiaries
- if the IRS levies the account because you owe it money
- a series of substantially equal payments taken over your life expectancy, which has many caveats
- some plans also allow small penalty-free withdrawals for a birth or adoption ($5,000 per child) or a personal emergency ($1,000 a year)
Higher education, a first-time home purchase, and health insurance premiums while unemployed are exceptions for IRAs, not 401(k)s.
Required minimum distributions (RMD’s) generally start at age 73. If you are still working for the employer that sponsors your 401(k), and you don’t own 5% or more of the company, your plan may let you wait until you retire. RMD’s are different for everyone. It is best to use Publication 590-B that you can get from the IRS. The tables and charts can help you calculate your RMD amount. I have also found that the institution your account is housed with will also tell you what your distribution should be.
2. Roth 401(k)
The Roth 401(k), sometimes called a designated Roth account, works in reverse. The investment into the Roth 401(k) is made after taxes are paid. These become tax free upon withdrawal at 59 1/2 and if they had the account open for at least 5 years.
If your employer offers this and you think you will be in a higher tax bracket when you retire this may be the better option. In some cases, if your employer offers both you may be able to split investments between the two accounts.
Roth 401(k)s are no longer subject to the RMD’s as of 2024.
3. SIMPLE 401(k)
The word SIMPLE is actually an acronym for “Savings Incentive Match Plan for Employees”. These are designed for small businesses that have less than 100 employees.
With this plan employees can contribute up to $17,000 for 2026. Those 50 and older can add a $4,000 catch-up, for $21,000 in all ($5,250 instead of $4,000 at ages 60 to 63). Upon retirement the money is taxed the same way as a traditional 401(k).
The employer is required to make a matching contribution of up to 3% or they can do a nonelective contribution of 2%. A nonelective contribution is when an employer elects to contribute regardless of whether or not the employee contributes.
Like a traditional 401(k), a SIMPLE 401(k) can be subject to penalties if withdrawn prior to age 59 1/2 and if you do not take the required minimum distributions after age 73.
4. Safe Harbor 401(k)
A safe harbor 401(k) lets an employer skip the yearly nondiscrimination tests in exchange for making required contributions for employees.
The nondiscrimination tests check that a plan does not favor highly paid employees over everyone else. They don’t require everyone to be treated identically, but the plan’s contributions and benefits can’t tilt toward the top earners.
For an employer-sponsored retirement plan to be eligible for certain tax benefits, they need to meet the requirements of the IRS and ERISA. They also have to be maintained when transferred or amended.
Employers that offer safe harbor 401(k)s must make a required contribution every year, no matter how long the employees have worked for the company. It is either a match for employees who contribute, or a nonelective contribution of 3% of pay for every eligible employee whether or not they contribute (the three options are listed below). In a traditional safe harbor plan these contributions are immediately vested.
How do 401(k) Plan Vesting Schedules Work
Any contributions you make to your retirement plan belong to you. The contributions made by your employer work differently.
Employer contributions may be dependent on a vesting schedule. A vesting schedule in a 401(k)-retirement plan may require an employee to have worked for the company a certain number of years in order to keep the employer’s portion of the contributions.
Depending on the employer, you may be subject to forfeiting some or all of the employers’ contributions. This can range from 0% - 100% depending on how long you have worked for the company. For example, if you are 0% vested it means you only get to keep your portion of the contributions. If you are 100% vested it means you get to keep yours and the employer’s contributions.
Another example: if your plan fully vests after 3 years and you quit after 2, you lose the employer’s contributions. You never have to pay anything back; you just don’t keep the unvested part. By law, employer contributions must vest at least as fast as all at once after 3 years, or gradually over 6 years.
Safe harbor 401(k)s have the same rules as other employer 401(k) plans on withdrawing early, contributions, and required minimum distributions.
For those with multiple 401(k) plans, you cannot exceed the maximum contribution. This means if you have an employer 401(k) and you are self-employed and own a small business 401(k) you would not be allowed to exceed $24,500 in your own contributions for 2026 ($32,500 if you’re 50 or older, or $35,750 at 60 to 63) between the 2 of them.
5. One-Participant 401(k)
Also known as solo 401(k), or self-employed 401(k). These are designed for business owners and a spouse if the spouse also works in the business, and they do not have employees.
The advantage of these is that the owner can contribute as an employee and as an owner since they are considered both.
Each spouse can contribute as an employee up to the employee limit ($24,500 for 2026, and never more than they earn), then the business can add a nonelective contribution as the employer. The maximum contribution will depend on how they are set up. Are they set up like a sole proprietorship, or S-Corporation?
Employee and employer contributions together can be as much as $72,000 per spouse for 2026, plus catch-up contributions for those 50 and older ($8,000, or $11,250 at 60 to 63).
3 ways Employers Can Make Safe Harbor Contributions:
- Basic match: The employer matches 100% of each non-highly compensated employee’s elective contributions, up to 3% of their compensation. Also, it matches 50% of the next 2% in compensation. So, for example, an employee who earns $50,000 a year would be eligible for a maximum match of $2,000 (100% of their first $1,500 in contributions plus 50% of the next $1,000).
- Enhanced match: The employer can base its match on up to 6% of the employee’s compensation, rather than just 5%, as with a basic match.
- Nonelective contribution: The employer contributes an amount equal to 3% of compensation on behalf of each non-highly compensated employee. Employees are not required to contribute.
What kind of investments are in a 401K
The majority of 401k’s are in some type of mutual fund. These include:
- Bond mutual funds: bonds are also known as fixed income. They are loans to big companies or governments. You agree to loan your money in return for a set rate of interest, for a set period of time which usually pays out twice a year. These can be long, short-term bonds.
- Stable value funds: these are very conservative as the name suggests “stable”. They are low yield but safe. Those that invest in these are usually close to retirement.
- Stock mutual funds: Funds that follow the S & P 500 are a favorite. The index holds about 500 large American companies, chosen by a committee rather than strictly by size, and when a company no longer fits, a new one takes its place. Dividend stocks are also popular. A dividend is a sum of money paid out to shareholders from the company’s profits.
- Target-date mutual funds: this is a combination of stocks and bonds where the investment can shift from one to the other based on when you want to retire.
Some 401k plans might allow you to manage your own portfolio to invest in individual stocks, bonds, or ETF’s. Only advisable for those who are knowledgeable with investing.
How Does Automatic Enrollment Work?
Is where an employer automatically enrolls an employee into a 401(k) by deferring a portion of their earnings into a 401(k) on their behalf. Employees can still opt out, but they must notify the employer of their wishes not to participate.
What Does Vested Mean in a 401(k) plan and How Does it Work?
As soon as an employee contributes to a 401(k) plan they are vested immediately. However, the employer’s matching contributions can be different depending on the plan. Some employers’ matches vest gradually over as many as 6 years, or all at once after up to 3 years. It is best to look at the employee handbook for the details.
With a traditional Safe Harbor 401(k) the required contributions are vested from day one. (A version that automatically enrolls employees can make you wait up to 2 years.)
What Are the Risks in 401(k) Plans
- Being too conservative: This would be having your 401(k) in low-risk investments like treasuries or bonds. The problem with this is that if the interest rate (return) is less than the inflation rate, you are losing money over time.
- Investment Losses: Happens when your investment decreases in value. Usually, it is when there is an economic downturn. Economic downturns usually last between 9 and 18 months.
- Paying too much in fees: The biggest culprit to these fees are actively managed funds. Index funds, whether mutual funds or Exchange Traded Funds (ETF’s), usually have much lower fees.