Getting Down to Basics:  What is the Purpose of a 401k Plan?

The personal finance blogosphere is chock-full of information about 401k plans.  Much of that information involves detailed examination of plan performances, options and the particular tax implications of different maneuvers.  That’s important information and it’s undoubtedly extremely helpful for many people.

However, it’s important to remember that a lot of people aren’t as interested in those detailed examinations as they are in the basics.  That’s why I decided to answer a core question that’s on the mind of many who are just starting their journey to better understanding personal finances:  What is the purpose of a 401k plan?

What is a 401k Plan?

BabyBoomCaretaker provides a simple working definition of a 401k plan:

A 401K plan is a qualified beneficial retirement savings plan which allows employees working for a private company or a corporation to save for life post retirement. It is like setting up a personal pension account for life after retirement and gathering adequate funds to live a salary-free life during the old age.

ABCInvesting’s definition is also helpful:

A 401k plan is a company-sponsored savings plan designed to help workers provide for their own retirement.  From the company’s point of view, the purpose of a 401k plan is to relieve the company of the responsibility to provide a traditional pension plan.  From the employee’s point of view, the purpose is to save for retirement.

I like both of those definitions because they do more than outline what a 401k is, in a general sense.  They also point toward the reason we have them in the first place–as a means of saving for retirement.

The Historical Purpose of the 401k Plan

Originally, 401k plans were considered an ancillary part of providing oneself with sufficient resources to fund one’s retirement.

When people retired and received their gold watches, they knew they were going to receive Social Security retirement benefits and a pension from their employer.  The 401k was seen as a way for them to sock away even more money to help supplement those “sure things.”  401k plans were supposed to provide a little extra “cushion” to make retirement more stable and comfortable.

Times Changed and So Did the Purpose of the 401k

Unless you’re right on the verge of retirement or incredibly optimistic, you probably aren’t wholly convinced that Social Security benefits will carry a significant portion of your retirement’s financial burden.  The nation’s changing demographics, government spending issues and a host of other factors have increased concern about the stability and probable levels of benefits.

At the same time, company pensions have been drying up and people are far less likely to stay at a single employer for an extended period.  As such, it’s a lot tougher to believe that you’ll ever see the gold watch or the subsequent monthly checks from your employer after you decide it’s time to retire.

Those changes have also changed the role of 401k plans.  They’re now a primary means of saving for one’s retirement.  401kPlanning.org explains:

Over the past 25 years, 401k’s have evolved from their original supplemental role to a new role of elevated importance. According to the Center for Retirement Research at Boston College, 63% of workers with pension coverage today have a 401k as their primary or only plan. The 2008-09 market downturn has generated much discussion as to whether 401k’s are up to the task as serving as the main retirement funding vehicle for Americans.

So, What is the Purpose of a 401k Plan?

A 401k plan is a means of funding your own retirement.  In order to encourage people to use them accordingly, the government has made them a tax-friendly investment vehicle.  The fact that employers often match some level of employee contributions increases their value in funding retirement, as well.

That’s the reason why 401k plans exist.  In upcoming posts, we’ll cover some other important basics about the 401k plans, the mechanics of how they work, and how one should approach their use and administration.