History

• Prior to the 1980s, most U.S. companies used annuities as retirement vehicles for employees. In 1978, Congress passed a change to the Internal Revenue Service tax code. Section 401k of the amendment allowed employers to begin making deferred compensation payments to employees. Between 1979 and 1982 companies such as PepsiCo and Johnson and Johnson established 401k plans to replace more expensive defined benefit retirement plans. The Sarbanes-Oxley Act of 2002 added layers of regulation to protect employees from insider trading after the collapse of Enron.
  
  

Features

• 401k plans allow investors to select mutual funds to invest in that match their retirement time-frame and investment experience. Aggressive funds containing mostly stocks enable people to try and outpace inflation through growth. Investors close to retirement invest in low-volatility funds containing government or corporate bonds that generally offer returns slightly above inflation. As employees near retirement, 401k plans enable them to switch from aggressive to more conservative plans. Some participants routinely switch investment strategies based on market conditions.
  
  

Time Frame

• Most companies allow employees to participate in 401k plans almost immediately but many do not make matching contributions for at least a year. 401k plans are intended to fund retirement and withdrawals prior to age 59 1/2 incur a 10 percent IRS penalty in addition to the assessment of regular federal and state income tax. When a plan participant reaches age 70 1/2, the IRS requires them to begin withdrawals from the 401k account, because up to that point, the funds have never been taxed.
  
  

Considerations

• 401k plans are protected by the 1974 Employee Retirement Income Security Act, which forces companies to keep retirement plans apart from other company accounts. The value of a 401k plan will not be impacted by a company going bankrupt, other than the lost value of shares in the company stock that it may or may not contain. Most plans limit the amount of company stock that employees own to minimize employee impact if the company fails.
  
  

Warning

• 401k plans do expose investors to market fluctuations and are not principal protected by the Federal Deposit Insurance Corporation. Conservative investments such as bonds can lose value and rely on the financial strength of the issuing entity. Growth in a 401k portfolio is not realized until it is converted to cash. People who choose to select ultra conservative mutual funds containing treasury bills, and commercial paper often find that fund operating expenses offset any earnings they make.