As a former pension actuary, retirement saving is one of my favorite personal finance topics. I’ve written several posts on 401(k) vs IRA, and today I’ll be talking about the history of these retirement saving plans and making some observations about how the history affects the current retirement saving pictures.
Traditional IRA was the first one to be born, established in 1974 by the Employer Retiree Income Security Act (ERISA). The original annual contribution limit was the smaller of $1.5k and 15% of income. The limit has been gradually increased over the last 4 decades to the current $5.5k. In 1986, the tax deduction was phased out for high-income taxpayers who were covered by an employer retirement plan, most likely a pension plan). In 1996 and 1997, new tax laws allowed more taxpayers to contribute and qualify for the tax deduction.
401(k) is technically a section in the Internal Revenue Code which was added in 1978 (almost 40 years ago now!). The original purpose of the section was to formally allow executives to invest part of their income in the stock market and thus defer paying income tax. 2 years after the section was enacted into law, a benefit consultant named Ted Benna realized employers could take advantage of this section to create a tax-deferred retirement saving vehicle for their employees. He went on to create the first 401k plan ever, for his employer. According to Wikipedia, the original contribution limit was 25% of income, up to $30k per year (remember this was in 1978 – you see, the IRS restructured the contribution limit at one point – the limit in 2018 is $18.5k). You can guess the IRS wasn’t too happy with the huge revenue deferral once other employers caught on and suddenly there were millions of 401(k) accounts. The next retirement saving accounts to be created would not be tax-deferred.
In 1997, in the effort to extend the coverage of the IRA to high-income taxpayers, some US politicians, including William Roth, introduced the Roth IRA. The Roth IRA was accepted by the congress as its effect on tax revenue would materialize beyond the ten-year time window for congress budget considerations (if you remember, the tax revenue loss for a Traditional IRA happens immediately, while that for a Roth IRA doesn’t take place until the individual withdraws the investment earnings). In the last 20 years, the Roth IRA has surpassed the Traditional IRA in participation rate: according to research by the EBRI, more individuals owned a Roth IRA account than owned a Traditional IRA account.
Finally, the Roth 401k was enacted into law in 2001, but was delayed until 2006 to be implemented. My guess is that the introduction of the Roth IRA was a way to collect tax revenue upfront. Partially due to the short history, Roth 401k has been relatively unpopular: according to Vanguard, only 13% of their retirement plan participants elected the Roth option in 2016. This figure has been growing, however, according to Aon-Hewitt, as many participants, especially the young folks, recognize the benefits of a Roth 401k. But notice the contrast with the 401k picture.
I hope this brief history was fun to read! And don’t forget to contribute to your IRA for the 2017 tax year by April 17, 2018 if you haven’t already. Please leave questions and comments below – I love reading those! See you in the next posts.