401(k) plans have become one of the most widely-used retirement-saving methods and in the United States, and a big part of a lot of American people’s financial planning strategy. How did this popular savings plan get its start and why is it so prevalent?

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This plan became law in 1978 when Congress amended the IRS code by adding section 401(k). The original purpose provided taxpayers a way to save taxes on deferred income, as taxes are deferred until funds are withdrawn. This provision was not associated with retirement planning until 1980, when benefits consultant, Ted Benna, also known as the father of the 401(k), realized its money-saving potential.

401(k)plans are sponsored by public and private firms in the United States for the benefit of their employees. Employees fund their 401(k) savings plans by allocating a percentage of their paycheck each month to their 401(k). As an additional incentive, firms often contributea small percentage of the firm’s revenue or profit to the employee’s 401(k). These 401(k) funds are designed to grow in the employee’s tax-sheltered account until retirement.

Growth in a 401(k) can be achieved through investments of various types, including stocks, bonds, and mutual funds. Risk tolerance should be determined carefully by the individual, balanced with the need for growth. A longer investment time horizon of 10 or 15 years can often mean greater tolerance for volatility and market fluctuations, but individual risk tolerance is also important. Guidance from a professional financial advisor is generally recommended and is important both when young and just starting to save or when getting close to retirement. Changes such as marriage, divorce, birth of a child, death of a parent, or a sudden influx of wealth are also reasons to seek input from an advisor.

What about taxes? Contributions to a 401(k) and earnings inside the account are taxed when they are withdrawn, preferably in retirement when retirees stop working, their incomes decrease, and tax rates are lower. (Note that tax rates do not always decrease in retirement and can increase depending on income, wealth, and asset levels.) The ability to defer taxes on current income andgrow assets tax-deferred until retirement from work are considerable benefits to the 401(k) owner!

With so many benefits to having a 401(k), it’s no wonder 60 million Americans have signed up for one.

Jim Bell, CFP is the President of Bell Investment Advisors, a Financial Advisory firm located in the San Francisco Bay Area he founded in 1991.

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