408(k) Plan vs. 401(k) Plan: An Overview
Both 408(k) and 401(k) refer to sections of the Internal Revenue Code that outline employer-sponsored retirement plans. Both provide guidelines that allow employees to set aside a portion of their paychecks before taxes are taken out to be invested in a special account meant for retirement. That's where these two alphanumeric codes diverge. While 401(k) has become synonymous with a widely available retirement savings vehicle, 408(k) sets the guidelines for what is more commonly known as the Simplified Employee Pension or SEP IRA.
- 408(k)s and 401(k)s are both retirement savings plans that employers can offer to employees.
- 401(k)s are the most common type of plan.
- The main thing that sets the SEP IRA apart from the 401(k) is that is it only available to companies with 25 employees or fewer.
- Unlike a 401(k), employee contributions are not permitted as part of SEP contribution limits.
According to the IRS, "SEPs were authorized by Congress in 1978 to provide employers with a simpler, less complicated manner of providing retirement benefits for themselves and their employees. Section 408(k)(1) of the Internal Revenue Code defines a SEP as an individual retirement account or individual retirement annuity with respect to certain participation, contribution, discrimination and withdrawal requirements being met."
SEP IRAs may be contributed to by employers even when the employee is also the employer. Employers may make tax-deductible contributions on behalf of eligible employees—including the business owner—to their SEP IRAs. The employer is allowed a tax deduction for plan contributions that do not exceed the statutory limit.
A 401(k) is the most common type of retirement savings account offered. It is a qualified, employer-sponsored savings plan. Employers offering a 401(k) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings in a 401(k) plan accrue on a tax-deferred basis.
The main thing that sets the SEP IRA apart from the 401(k) is that is it only available to companies with 25 employees or fewer. Here are some other features.
- Only employers contribute to a SEP. Unlike a 401(k), employee contributions are not permitted as part of SEP contribution limits.
- Contribution limits. Employers can contribute as much as 25% of an employee's salary, but no more than $56,000 (up from $55,000 in 2018). No catch-up contributions are allowed, as SEP IRAs are funded only with employer contributions.
- Separate, personal IRA contributions. If your company's SEP IRA plan permits it, employees can make their own IRA contributions to the same account, up to the IRA limits ($5,500 in 2018, $6,000 for 2019—plus an additional $1,000 for those age 50 or older.)
- Minimum earnings to be eligible. The minimum compensation threshold remains unchanged at $600.
- The maximum compensation that can be considered. No matter how much an employee earns, the annual compensation limit that can be considered in determining contributions to a SEP IRA, according to the IRS is $280,000 in 2019, up from $275,000 in 2018.
- Contributions are not taxed. As with a 401(k), employer contributions to your section 408(k) plans are not taxed.
- Who can have one. Employees of companies with 25 employees or less. People who are self-employed who would normally not have access to a retirement plan.
- Contributions can be tax-deductible. Self-employed people with a SEP IRA can deduct the cost of a certain amount of personal contributions to their retirement funds from their income.
- Employer contributions under a SEP IRA must be equal. That means that each eligible employee must get the same percentage of their salary contributed to the plan.
- Contribution deadlines follow the IRA deadlines. For example, 2018 contributions to a SEP IRA may be made until April 15, 2019, or until October with a filing extension. With a 401(k), the deadline is the calendar year.
- Employees, not employers, manage a SEP account. Overall, 401(k) plans are a bit more complex than SEPs, with many investment options set up by the employer including mutual funds that contain stocks, bonds, and commodities. With a SEP IRA, the employer does not set up investment options. Instead, the employee manages the SEP IRA on their own, choosing their own investments. Employers essentially put money (not real property, which is forbidden) into individual employee individual retirement accounts (IRA). This saves the employer from paying administration costs like they would for 401(k) management.
- Penalties for early withdrawal. Both types of accounts are inaccessible without a penalty until the account holder reaches the qualified age of 59½.