408(k) Plan: What it is, How it Works, Compared to 401(k)
What Is a 408(k) Plan?
A 408(k) plan is a type of employer-sponsored retirement savings plan, often referred to as a Simplified Employee Pension (SEP) plan. It falls under the broader category of retirement planning and allows employers to contribute to individual retirement accounts (IRAs) established for their eligible employees. This plan is characterized by its administrative simplicity and is particularly suited for small businesses and self-employed individuals looking for a flexible way to save for retirement. Contributions made to a 408(k) plan grow on a tax-deferred basis until withdrawal in retirement.
History and Origin
The concept of the Simplified Employee Pension (SEP) IRA, commonly known as a 408(k) plan due to its governing Internal Revenue Code section, was established by the Revenue Act of 1978. This legislation aimed to provide a simplified, cost-effective retirement savings option primarily for small businesses that might find more complex plans challenging to administer. Before this act, retirement plan options for smaller entities were often burdensome. The Revenue Act of 1978 played a significant role in reforming various tax provisions, including changes that ultimately paved the way for more accessible retirement savings vehicles like the 408(k) plan.8
Key Takeaways
- A 408(k) plan is an employer-sponsored retirement plan, also known as a Simplified Employee Pension (SEP) plan.
- Only employers can contribute to a 408(k) plan, and contributions are made to an employee's Individual Retirement Account (IRA).
- These plans are known for their administrative simplicity and flexibility, making them appealing to small businesses and the self-employed.
- Contributions are tax-deductible for the employer and grow tax-deferred for the employee.
- Employees are immediately 100% vested in all contributions made to their 408(k) plan.
Interpreting the 408(k) Plan
A 408(k) plan is interpreted as a straightforward and cost-effective method for employers to fund their employees' retirement. Unlike some other plans, it does not involve complex administrative hurdles such as extensive annual reporting or testing. This simplicity is a key advantage, especially for businesses with limited human resources or those seeking to minimize overhead associated with benefits. The plan operates by directing employer contributions into a Traditional IRA for each eligible employee. The Internal Revenue Service (IRS) provides detailed guidance on these plans in publications like IRS Publication 560, which outlines the rules for setting up, contributing to, and maintaining various retirement plans for small businesses.7
Hypothetical Example
Consider "Alpha Solutions," a small consulting firm structured as a sole proprietorship with two employees, John and Jane. The owner, Mark, decides to establish a 408(k) plan for the business.
At the beginning of the year, Mark informs John and Jane that he will contribute 15% of their compensation to their respective 408(k) plans. John earns $60,000, and Jane earns $50,000.
- John's Contribution: 15% of $60,000 = $9,000
- Jane's Contribution: 15% of $50,000 = $7,500
Mark, as the owner, is also eligible to contribute to his own 408(k) plan. If his net earnings from self-employment (after deducting half of self-employment taxes and SEP contributions) are $100,000, he can contribute up to 25% of his adjusted net earnings, or the annual dollar limit, whichever is less. Assuming his contribution rate matches his employees, he would calculate his contribution based on a specific formula for self-employed individuals.
These contributions are deposited directly into John's and Jane's individual SEP-IRA accounts. John and Jane then have the ability to choose how these funds are invested within their respective accounts, just as they would with a regular IRA. The contributions are tax-deductible for Alpha Solutions, reducing the firm's taxable income for the year.
Practical Applications
408(k) plans are widely utilized by various types of small businesses, including partnerships, corporations, and self-employed individuals. They serve as an accessible means for employers to offer valuable retirement benefits without the administrative complexity and costs often associated with larger, more traditional plans. For businesses with fluctuating income, the flexibility to vary annual contribution amounts, or even skip contributions in lean years, is a significant advantage. The funds held within a 408(k) plan are subject to rules laid out by the IRS, specifically in IRS Publication 560.5, 6
The Department of Labor (DOL) also plays a role in overseeing retirement plans, including ensuring that plan fiduciaries meet their fiduciary responsibilities under the Employee Retirement Income Security Act (ERISA). While 408(k) plans have fewer ERISA requirements than 401(k)s due to their nature as IRAs, the DOL's broader mandate to protect retirement plan participants means it provides guidance and oversight for various retirement savings vehicles.3, 4
Limitations and Criticisms
Despite their simplicity, 408(k) plans have certain limitations. A primary drawback is that only employer contributions are permitted; employees cannot make elective salary deferrals. This differs significantly from plans like a 401(k) where employees can contribute directly from their pay. Additionally, employers must contribute the same percentage of compensation for all eligible employees, including themselves. This rule can be restrictive if an employer wishes to contribute more to their own retirement savings than they are willing or able to contribute for all their employees at the same percentage.
Furthermore, while 408(k) plans offer high contribution limits compared to traditional IRAs, they may still be lower than those allowed in some advanced defined contribution plans like 401(k)s, especially when considering employee deferrals and employer matching contributions. The funds in a 408(k) are subject to the same early withdrawal rules as a Traditional IRA, generally incurring a 10% penalty if withdrawn before age 59½, with certain exceptions.
408(k) Plan vs. 401(k) Plan
The 408(k) plan and the 401(k) plan-plan) are both popular employer-sponsored retirement savings options, but they differ significantly in structure, flexibility, and administrative burden.
| Feature | 408(k) Plan (SEP IRA) | 401(k) Plan |
|---|---|---|
| Contributions | Employer only; no employee elective deferrals allowed | Both employer (matching/profit-sharing) and employee (elective deferrals) contributions allowed |
| Flexibility | Employer can vary or skip contributions annually | Employer contributions often tied to employee deferrals or fixed formula; generally less flexible year-to-year |
| Administrative Ease | Very simple; minimal paperwork and reporting | More complex; requires regular testing, compliance, and detailed record-keeping |
| Eligibility | Broader, often includes part-time employees (e.g., 21+, worked 3 of 5 years, $750+ compensation) 2 | Can be more restrictive for part-time employees depending on plan design |
| Vesting | Immediate 100% vesting for employees | Vesting schedules (e.g., graded or cliff) can apply to employer contributions |
| Setup Cost | Low to negligible | Higher, due to setup and ongoing administrative fees |
| Primary Beneficiary | Small businesses, self-employed | Businesses of all sizes, particularly larger ones, due to scalability and complexity |
The key distinction lies in employee contributions and administrative overhead. A 401(k) plan allows employees to save a portion of their pre-tax income directly from their paycheck, often with an employer match or profit-sharing plan component. This makes it a powerful savings tool for employees. However, 401(k) plans come with substantial administrative requirements, including non-discrimination testing, which can be burdensome for smaller employers. The 408(k) plan, in contrast, streamlines the process by limiting contributions to the employer, thereby reducing the compliance complexity.
FAQs
Q: Can employees contribute to a 408(k) plan?
A: No, only the employer can contribute to a 408(k) plan. Employees cannot make elective deferrals to their SEP-IRA accounts.
Q: What are the main benefits of a 408(k) plan for a small business?
A: The main benefits include administrative simplicity, low setup and maintenance costs, tax-deductible contributions for the employer, and flexibility to adjust contributions annually based on business profitability. It provides an easy way for small businesses to offer retirement benefits.
Q: Are there income limitations for contributing to a 408(k) plan?
A: While there are no income limitations for who can establish a 408(k) plan, the amount an employer can contribute is limited annually. For 2024, the maximum contribution to an employee's 408(k) plan cannot exceed the lesser of 25% of the employee's compensation or $69,000. These contribution limits are subject to annual adjustments by the IRS.
Q: How does the IRS oversee 408(k) plans?
A: The IRS outlines the regulations for 408(k) plans primarily through Section 408(k) of the Internal Revenue Code and provides detailed guidance in publications such as IRS Publication 560. The IRS ensures compliance with contribution limits, eligibility rules, and distribution requirements.1