The 401(k) retirement plan was authorized by the Revenue Act of 1978, which took effect in 1980, but its real genesis is the 1974 Employee Retirement Income Security Act, which fixed the problem of underfunded defined-benefit plans so thoroughly that private employers stopped offering them. Benefits consultant Ted Benna came up with a way to use the 1978 Act for a tax-deferred, defined-contribution plan and the rest is history.

The tax advantage of a 401(k) depends on four factors, all of which have changed dramatically since 1980 to the detriment of 401(k)s. For a median-income married couple with two children:

1. The marginal federal income tax rate was 43% in 1980, 12% today

2. The capital gains tax rate was 28% in 1980, 0% today 1

3. The likely retirement bracket tax rate was 15% in 1980, 12% today

4. Interest rates in 1980 were around 15%, compared to 0% today

Making some reasonable assumptions about a worker with 30 years to retirement, the 1980 version of the 401(k) tax deferral was equivalent to an additional investment return of 9.2% per year, an extraordinary incentive to save for retirement, even without an employer match. Using today’s numbers the benefit comes out to 0.6%, considerably less than the 1% to 2% in fees investors pay in typical 401(k) plans.

That example compares investments paying ordinary income tax rates yearly. But investors also have the option of using tax-efficient investments taxed mainly at capital gains rates at time of withdrawal. In the 1980 environment, the 401(k) plan had a 2.5% annual advantage over tax-efficient investments in a taxable account. In 2020, there is no tax advantage remaining to the 401(k).

So in 1980, the government offered a huge tax savings to encourage retirement savings, while today it offers little or no benefit. The employer contribution is still valuable, with a 100% match worth 2.3% per year in extra return over 30 years, but this has nothing to do with the 401(k) structure. 

Another big change since 1980 is the availability of zero-cost, tax-efficient, well-diversified index funds in convenient form for retail investors. Yes, 401(k) plans have reduced costs as well, but to a much smaller degree. In 1980, a typical investor might have paid 3.5% of assets in fees either in or out of a 401(k). In 2000, that’s shrunk to perhaps 1.5% in a typical 401(k), and 0.5% outside. Some employers offer 401(k) with fees equal to or even lower than taxable alternatives, but others are stuck around the 3.5% level.

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