The Arrival of the 401k

Justin Fox is the business and economics columnist for Time magazine. He also writes the Curious Capitalist blog for time.com.

Ed Slott, a New York CPA and author, was named as a source for IRA advice by The Wall Street Journal and called "America's IRA Expert" by Mutual Funds Magazine.

In the past 20 years, the 401(k) has overtaken the pension as Americans' dominant source for retirement funding. Today 56 million Americans have access to a 401(k) savings plan, while only about 17 million workers in the private sector have pensions. Financial experts Justin Fox and Edward Slott explain the evolution and purpose of the 401(k).

How did the 401(k) come about?
Justin Fox: "In 1974 Congress passed the ERISA (Employment Retirement Income Security Act) which was designed to help protect workers from these irresponsible corporations that went bankrupt and didn't have enough money set aside in their pension funds. And basically that and some accounting changes that came along a few years later made it so that if you are a corporation and you are promising your workers a pension, you had to set aside a ton of money to take care of that. Most corporations that have come along since the late 70s have decided, 'well, we're not going to do that. We're not going to get beyond the hook for these expenses 40 years in the future, so we'll put that risk on my employees instead. Microsoft, Intel, all of the sort of great new companies that arose in the 70s, basically all of them have done without traditional pension, and what has been happening over the last 15 years or so is that we're seeing the big traditional companies, the IBMs, basically any company that is not dominated by union employees, switching to that same model, away from the pension and towards the self-directed model. With the 401(k), the particular self-directed model that most everyone has picked up, it came about when a pension consultant in Pennsylvania figured out this interesting loop hole in the tax code – this thing called Section 401k that allowed companies to set up these tax sheltered individual retirement plans for employees.

What's the difference between a 401(k) and an IRA?
Edward Slott: "The difference is that the 401(k) is a company-sponsored plan. It may be your money, but it is not your plan. It is run by the rules of the company, so you may not be able to take your money out whenever you like, there are certain triggering events in the plan, reaching a certain age, separation from service, retirement age in the plan when you're allowed access to your money. With an IRA, it is your money and your plan. You can take the money out of an IRA anytime you wish. Of course there may be penalties, for example if you take it out before 59 and a half, but you always have access to your own money in an IRA, not true with a plan. So that is the big difference between a 401K and an IRA and a reason why when you are coming into retirement, you may be better off having the money in an IRA with which you control withdrawals on your schedule."

What's the difference between an IRA and a Roth IRA? (or a 401(k) and a Roth 401(k)?)
Edward Slott: "The traditional 401(k) or the traditional IRA is a vehicle where you put money in and you get a tax deduction for the money you put in. But when you take it out on the back end, it is all taxable plus the earnings. With a Roth, it is the other way around. You put the money in and don't get a tax deduction up front, but on the back end, you get a windfall – withdrawals are tax free for the rest of your life. The last thing on earth you want in retirement is to have to pay taxes on the money you are pulling out. I believe rates are probably as low now as we will ever see them. So I would recommend saving for retirement now, with the Roth option both in a 401(k) and in an IRA."