401(k) Plans

Since 1978, section 401(k) of the Internal Revenue Code has allowed for-profit businesses to establish salary-reduction plans. Also known as cash or deferred arrangements, or CODAs, 401(k) plans grew rapidly in popularity over the ensuing two decades. They now are the most common form of defined-contribution plan and are offered not only by for-profit businesses but also by some nonprofits and state and local governments. In 2005, 73 percent of the employees of medium-sized and large establishments and 33 percent of the employees of small establishments participated in such plans. Most employers match at least a portion of their workers' contributions as part of a savings and thrift plan; however, about 30 percent of participating employees received no contributions from their employer in 2005.

Tax-deferred contributions by employees to their 401(k) plans in 2006 are limited by law to $15,000. In the future, that limit will be indexed for inflation. Currently, contributions to SIMPLE 401(k)s are limited to $10,000. Tighter limits on contributions than those required by law are also imposed by most employers--but as a percentage of compensation rather than as a dollar amount. The average limit in 2002 was 16.5 percent. The employer-imposed limits may be the legacy of pre-EGTRRA rules limiting an employer's deduction for contributions to 15 percent of compensation, or they may be intended to keep plans within the nondiscrimination rules.

The changes enacted in EGTRRA in 2001 relax the tax code's limit on deductions somewhat and allow participants ages 50 and older to make "catch-up" contributions. Participants are eligible for the catch-up option if they are otherwise prohibited by any provision of the plan or by the tax code from making further contributions. Thus, for example, a 50-year-old employee who earns $50,000 but whose contribution to his or her retirement plan is limited to 10 percent of compensation by the plan's provisions could nevertheless contribute more. Furthermore, that extra amount would have no bearing on nondiscrimination testing. In 2006, the maximum catch-up contribution is $5,000. The limits on catch-up contributions to SIMPLE 401(k) plans are half those imposed on contributions to regular 401(k) plans. Thus, the effective maximum annual contribution to 401(k) plans for participants ages 50 and older is $20,000 ($13,000 for SIMPLE 401(k)s).

EGTRRA also introduced two other features to 401(k) plans: first, between 2002 and 2006, the law allows low-income contributors to claim a nonrefundable tax credit for a portion of their 401(k) contributions; second, beginning in 2006, participants of any income level will have the option--subject to their employer's approval--of designating 401(k) contributions as "after tax," similar to contributions made to Roth IRAs. Employers that accept such contributions must account for them separately, because withdrawals from those accounts will be tax-exempt, as are withdrawals from Roth IRAs. EGTRRA also permits rollovers between those "Roth 401(k)" accounts and Roth IRAs.

Under the law governing 401(k) plans, the granting of investment control to employees is left to employers' discretion. Employees who are granted such control typically face a menu of three to 10 investment options; half of all employees with such options can choose from at least five. In most cases, employees can change their investments at will, but employers may limit the frequency with which they can do so. In 2000, 88 percent of full-time employees in the private sector who participated in 401(k) plans had some say in investing their own contributions, and 64 percent had some say in investing their employer's contributions.

Many 401(k) plans permit loans and early withdrawals. In 1997, nearly half of the employees of medium-sized and large establishments who participated in 401(k) plans could borrow against a portion of their balances for any reason, and an additional 6 percent could borrow because of hardship.⁽¹⁾ By contrast, early withdrawals were more likely to be limited to hardship cases. Although nearly half of the employees who participated in 401(k) plans in 2000 could make withdrawals, only 19 percent could do so for reasons other than hardship.