401(k) Basics: When It Was Invented and How It Works

Whether you want to retire to a quiet life on the beach or spend your golden years globetrotting to exotic locations, one thing is for sure: Retirement is likely to be the most expensive thing you ever pay for.

And unlike other major life purchases (cars, homes, college) there are no loans for retirement. That means you'll have to save for it.

Enter the 401(k). It’s a special account that you can sign up for at work, if your employer offers one, and it’s designed specifically to help you save for retirement. Here’s the 101 on 401(k)s.

A BRIEF HISTORY OF THE 401(K)

Why is it called a 401(k)? Despite their popularity today, 401(k) plans were created almost by accident. It started when Congress passed the Revenue Act of 1978, which included a provision that was added to the Internal Revenue Code — Section 401(k) — that allowed employees to avoid being taxed on deferred compensation.

In 1980, benefits consultant Ted Benna referred to Section 401(k) while researching ways to design more tax-friendly retirement programs for a client. He came up with the idea to allow employees to save pre-tax money into a retirement plan while receiving an employer match. His client rejected the idea, so Benna’s own company, The Johnson Companies, became the first company to provide a 401(k) plan to its workers.

In 1981, the IRS issued new rules that allowed employees to fund their 401(k) through payroll deductions, which kickstarted the 401(k)’s popularity. Within two years, nearly half of all big companies were offering 401(k)s or were considering it, according to the Employee Benefits Research Institute.

HOW A 401(K) WORKS

If your employer offers a 401(k) and you meet the eligibility requirements, you can enroll in the plan and begin making contributions via payroll. Before you start making contributions, though, you’ll need to decide:

• What type of 401(k) you want: Traditional or Roth
• How much you want to save
• What you want to do with the money you save

401(k)s come in two distinct flavors: Traditional and Roth. Although at their heart they aim to achieve the same purpose — to encourage Americans to save more for retirement by offering tax incentives — they do this in drastically different ways. Here are the main ways they differ.

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Traditional 401(k): Your contributions are made before taxes and over the years your money grows tax-deferred. This means the contributions you make help lower your taxable income now, and you don’t pay any taxes on either your contributions or investment growth until you begin making withdrawals in retirement. At that point, the money will be taxed as ordinary income.

Roth 401(k): Your contributions are made after you've paid tax on the income, but your money grows tax-free. Because you already paid tax up front, when you withdraw money during retirement, you won’t have to pay taxes.

Which one you choose will depend on a number of factors, including whether your company actually offers both (Roth 401(k)s are not as commonly offered as traditional 401(k)s) and whether you want a tax break now or later. It may be a good idea to do a mix of both to give yourself more options for how you withdraw money in retirement.

HOW TO MAKE CONTRIBUTIONS

How much you decide to contribute to your 401(k) is really up to you, but there is a maximum amount that is set by the IRS each year. For 2021, the annual contribution limit for workers 50 and younger is $19,500. Those 50 and older are allowed to add a “catch-up” contribution of $6,500 (which means they can contribute up to $26,000).

Apart from knowing the limits, other factors that’ll play into your contribution decision will include how much you think you’ll need to save for retirement, whether you’re saving for retirement through other types of accounts and how much you can actually afford to contribute each month.

Also, it’s a good idea to try to contribute enough to meet your employer match, which is free money. A company might, for instance, match half of the contributions you make on the first 6 percent of your salary, or match 100 percent of what you contribute up to a certain dollar amount or percentage of your salary. In some rare cases, your employer might even match what you put in dollar for dollar.

Once you know how much you want to contribute, you’ll choose how much you want deducted from each paycheck that will go straight into your 401(k). This could be either a percentage of your pay or a specific dollar amount. Your human resources department will explain to you how to do this when informing you about your benefits.

RELATED CONTENT: How much do I need for retirement? Our retirement planning guide can help you better understand the road to retirement — and how to craft a financial plan that’s built around your unique goals.

CHOOSING YOUR INVESTMENTS

Typically, a 401(k) plan offers a range of investments, which means you have to choose what to invest your money in. Your 401(k) plan provider will have options for you to choose from, which might include specific types of mutual funds or “default” offerings based on your risk tolerance (i.e., how well you can stomach market swings).

Many plans may also include something called target date funds, which are designed with your retirement timeline in mind. They might have riskier asset allocations to start, but become more conservative the closer you get to your target retirement date (hence the name).

MAKING THE MOST OF YOUR 401(K)

If you’ve started putting money into your 401(k), congratulations! You already made it past the hardest part, which is getting started. But don’t just set it and forget it. You’ve also got to keep your money growing. These tips can help.

Commit to raising your contribution periodically. Even just raising your contribution by 1 percent every six months or year can help, and it’s unlikely you’ll miss that amount from your paycheck, especially if you up your contribution whenever you get a raise. Some 401(k) plans even let you schedule an increase automatically.

Earmark portions of your raise or bonuses for retirement. If you receive a promotion that bumps your pay by, say, 5 percent, consider raising your contribution amount by the same percentage. Or if you’re expecting a big year-end bonus, consider sending some of that to your 401(k) for a one-time boost. Your future self will thank you.

No investment strategy can guarantee a profit or protect against loss. All investing carries some risk, including loss of principal invested.

This article is not intended as legal or tax advice. Northwestern Mutual and its financial representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting or tax adviser.

This article was updated May 7, 2019.