DEFINITION of '408(k) Plan'

A 408(k) plan is a retirement plan that an employer sets up for its employees to help them save. The 408(k) plan is a simplified version of the popular 401(k) plan, but is intended for smaller companies (those with fewer than 25 employees). It is also available to self-employed individuals. Under the plan, employees can contribute pretax dollars to the account and thus reduce their net incomes for the year. This results in a tax savings for the contributor.

BREAKING DOWN '408(k) Plan'

Although the term 408(k) is often used to describe an account, it actually refers to the Internal Revenue Code, which details simplified employee pension (SEP) accounts. The employee and the employer contribute to this account in the employee's name. Throughout the account's lifetime, deposits are not treated as income until the funds are withdrawn.

408(k) Plan and 401(k) Plan

Participation in traditional 401(k) plans continues to grow. As of December 2017 there were 55 million active participants in 401(k) plans, holding $5.3 trillion in assets. Once criticized for their high fees and limited options, 401(k) plan reform has made several changes to benefit employees. The average plan offers nearly two dozen different investment options, balancing risk and reward, according to the employees’ preferences.

At the same time, fund expenses and management fees have remained level and/or even declined, making this option feasible for more Americans. Additional features such as automatic enrollment, increased fee transparency, additional low-cost index fund options and catch-up contributions for near-retirees have been added to many plans. In addition, contribution limits are indexed to inflation, allowing participants to make larger contributions to plans over time. Still, better and more widespread understanding of 401(k)s, through education and disclosure initiatives, will continue to boost participation in 401(k) and 408(k) plans.

While the 401(k) plan is funded with pre-tax dollars (resulting in a tax levy on withdrawals down the line), a Roth 401(k) is another type of employer-sponsored investment savings account that is funded with after-tax money. This means that when an employee withdraws funds at the appropriate time, he or she will not have to pay taxes. If an employee makes premature withdrawals of contributions, however, he or she could be liable for taxes, along with a 10% penalty. This type of investment account is well-suited to people who think they will be in a higher tax bracket in retirement than they are now.

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