What Is a 408(k) Plan?
The term 408(k) account refers to an employer-sponsored retirement savings plan. A 408(k) plan allows employees to put aside pretax dollars away for retirement that grow on a tax-deferred basis, making it a type of individual retirement account (IRA). This means that individuals pay taxes when they make withdrawals after they turn 59½. Plans like these are intended for smaller companies and self-employed people. The 408(k) is commonly referred to as a simplified employee pension (SEP) plan; it is the SEP version of the popular 401(k) plan.
- A 408(k) is an employer-sponsored retirement plan akin to a 401(k).
- The plan is also referred to as a simplified employee pension, which is a type of individual retirement account.
- The 408(k) plan is available to companies with 25 or fewer employees and self-employed individuals who are subject to the same contribution limits as employers.
- Only employer contributions are allowed into the 408(k) plan.
- The IRS limits how much employers can contribute to their employees' 408(k) plans.
Understanding a 408(k) Plan
Section 408(k) of the Internal Revenue Code (IRC) outlines the rules and regulations associated with SEP and salary reduction simplified employee pension (SARSEP) accounts, notably individual retirement account or individual retirement annuities. That is why SEP plans are often referred to as 408(k) plans.
The IRC highlights the requirements needed in order to participate in a 408(k) plan. Plans are available to small business owners who operate with 25 or fewer employees and to self-employed individuals. Participants qualify if they are:
- Over the age of 21
- Worked for at least three of the last five years for the employer
- Were compensated at least $650 by the employer
Annual employer contributions cannot exceed the lesser of 25% of the employee's pay or $61,000 for 2022 ($66,000 for 2023). The annual compensation limit cannot be calculated on incomes exceeding $305,000 for 2022 ($330,000 in 2023). The maximum deduction claimed on a business tax return for contributions is the lesser of the total contributions into employees' accounts or 25% of compensation.
Plan holders can make withdrawals from their 408(k) plans at any time—the same way they would from traditional IRAs. But there are certain conditions that apply. For instance, most individuals make withdrawals after they turn 59½. Any distributions from these plans before that age incur a 10% early withdrawal penalty. Withdrawals must be made as required minimum distributions (RMDs) once you reach 72.
Unlike traditional retirement plans, SEPs don't have the same start-up or administrative costs.
408(k) Plans vs. 401(k) Plans
As noted above, a 408(k) is are one type of employer-sponsored retirement plan. The 401(k) plan is the most common option and is offered by the vast majority of American corporations. The plan allows taxpayers to make pretax contributions through automatic payroll deductions and employer matches for those that make them.
Plan reform has made several changes to benefit employees, including lower fees and investment options. The average 401(k) plan now offers nearly two dozen investment options by balancing risk and reward, in accordance with an employee's preferences. Unlike an SEP, employees may contribute to a 401(k) plan. And self-employed individuals who work for a company with a 401(k) can contribute to that plan, too.
Participation in traditional 401(k) plans continues to grow. These plans held roughly $7.3 trillion in assets by the end of September 2021, which represented about one-fifth of the retirement market in the United States. There were 600,000 active plans in the country with a total of 60 million employees and retirees in 2020.
Here are a few other facts related to the 401(k) that taxpayers should know:
- Contribution limits for 401(k) plans are indexed to inflation. The Internal Revenue Service (IRS) allows employees to save up to $20,500 for 2022 and $22,500 for 2023. Catch-up contributions of $6,500 per year (increasing to $7,500 in 2023) are also allowed for people 50 or older.
- Withdrawals before the age of 59½ often result in a 10% early withdrawal penalty, unless an exemption is applied. Taxes are imposed on any withdrawals made as contributions are made with pretax earnings.
- Individuals are required to take RMDs as of the age of 72.