What is a 408(k) Plan
What is a 408(k) Plan
A pension plan where small family businesses, employees in firms of less than 25, and the self-employed can benefit from tax deductions in contributions to a 408(k) plan or a simplified version.
408(k) Plan Details
408(k) is an Internal Revenue Code. It's used to describe a type of Individual Retirement Account or IRA known as a SEP or Simplified Employee Pension plan. These plans are often referred to as SARSEP or Salary Reduction Simplified Employee Pension schemes, and they aren't that different from the more common 401(k).
Contributions made to a 408(k) plan are tax-deductible, and the funds within the account are not treated as income, remaining tax-free until participants or their beneficiaries make withdrawals.
This employer-sponsored savings plan is designed for small businesses, preferably with less than 25 participants, sole proprietors, and other self-employed individuals. Employees don't contribute to their 408(k) plan accounts established and maintained by the employer.
401(K) Details for the Self Employed
Self-employed 408(k) plan participants who also work for employers can make retirement contributions to this SEP while benefiting from their employer's pension scheme. Employer contributions to the plan for the year 2021 cannot be more than 25% of their employee’s annual pay, or $58,000.
Salaries that exceed $290,000 aren't subjected to the yearly limit. A business can only claim a maximum tax return that's lesser than 25% of compensation or the total accounts for employee contributions.
Example of 408(k) Plan
A 408(k) plan proves useful and practical to workers seeing as employer’s contributions and their retirement savings are not taxed until pension’s maturity or benefits distribution. Other incentives occur when the deducted payments and saving for employers on their annual company tax bill lowers the employee’s net income and tax bracket.
For instance, an employer sets up a 408(k) plan for employees to benefit from retirement distributions when they reach the age of 59 and a half. The employer's contributions and the account savings are tax-deferred while future withdrawals on maturity are taxed as regular income.
The employee will also benefit from loans against the savings accumulated, and their repayments will be reverted to the 408(k) plan account balance.
If the participant or employee by whose name the IRA is set up makes an early withdrawal from the account, the IRS will assess a 10% penalty. This withdrawal penalty also applies to the traditional 401(k) plan, which is better suited for employees that might fall into a higher tax bracket by the time they retire.
Differences between a 408(k) Plan vs. 401(k) Plan
Both 408(k) and the 401(k) are employer-sponsored pension plans. They provide guidelines for employee retirement savings with tax deduction incentives. The 401(k) plan has become synonymous as the vehicle of choice for retirement savings. But unlike the 408(k), it suits larger organizations, and employee contributions are allowed.
Employers can offer 401(k) plans where they make non-elective or matching contributions on behalf of eligible participants, and they can also add features like a future profit-sharing plan. While accrued earnings are tax-deferred, 401(k) plans are more complicated due to the employer's options of investment. In retrospect, employees can choose investments on their retirement savings with a 408(k) SEP-IRA plan.
The main sticking point in terms of 408(k) and 401(k) plan differences is that the SEP-IRA is only available to companies with less than 25 employees. Here are a few other features that distinguish the two retirement savings options:
- With a 408(k) plan, employers can only contribute not more than 25% of an employee's pay, which means no more than $58,000. There are no catch up payments that can be made since a 408(k) plan is fully employer-funded.
- Some 408(k) plans can allow personal payments by the employee, separately from the employer's IRA contributions to the same account. These contributions are subject to limits, like $6,000 for the year, or age-eligible participants can add an additional $1,000.
- SEP IRAs have a maximum allowable compensation no matter how much an employee earns, with an annual limit of $290,000 for 2021. There's also a minimum compensation threshold for eligibility, which is earnings of $600 and below.
- Employer contributions for the 408(k) plan must be equal, meaning each employee receives the same percentage of salary deduction. Contribution to SEP IRAs by self-employed participants can be tax-deductible, allowing the costs for personal retirement funds to be deducted from their earnings.
- Deadlines for contribution payment s also differ, where 408(k) plans have until April or October with an extension. Contribution deadlines for 401(k) have a deadline which is the end of each calendar year.
SEP accounts are managed by the employee, not the employer, as is the case for 401(k) plans where the latter sets up investment options. The employee in a 408(k) plan scenario chooses their account's investments, and employers don't pay administration costs like 401(k) plans.
Significance of 408 (K)
408(k) plans come in handy, especially when an employee needs to take out a loan against the amount of savings contributed. The SEP-IRA account draws up a payment schedule with a plan administrator, and the repaid premiums go on to bolster that employee's retirement savings. However, if they default on their repayments for this loan amount, it's treated as an early distribution withdrawal and is subject to a 10% penalty.
Maximum contribution limits for a 408(k) differ every year as the IRS compensates for inflation. However, they do allow increased contributions if a participant reaches the age of 50. Hopefully, this can help them catch up with any payments that may have been missed over the years.