The 408(k) Plan
A Guide to Employer-Sponsored Retirement Savings
In the realm of retirement planning, the 408(k) plan, also known as a simplified employee pension (SEP) plan, offers a straightforward avenue for saving. Similar to an individual retirement account (IRA), it allows employees to set aside pre-tax earnings for the future.
Let's explore the basics of the 408(k) plan, its benefits, and what sets it apart from other options.
A 408(k) plan, also known as a simplified employee pension (SEP) plan, is an employer-sponsored retirement savings arrangement that allows employees to allocate pre-tax earnings towards retirement, akin to an individual retirement account (IRA).
Contributions made to a 408(k) plan accumulate tax-deferred until withdrawal, typically upon reaching the age of 59½. Unlike traditional IRAs, only employer contributions are permitted in the 408(k) plan, with employers and self-employed individuals subject to identical contribution limits. This plan is available to companies of all sizes and self-employed individuals seeking a straightforward retirement savings option.
Moreover, it's the SEP version of the widely recognised 401(k) plan. However, the Internal Revenue Service (IRS) imposes restrictions on the maximum contributions employers can make to their employees' 408(k) plans, ensuring compliance with regulatory guidelines.
Section 408(k) of the Internal Revenue Code (IRC) delineates the regulations governing SEP and salary reduction simplified employee pension (SARSEP) accounts, particularly individual retirement accounts (IRAs) or individual retirement annuities. Hence, SEP plans are often called 408(k) plans.
The IRC specifies the eligibility criteria for participation in a 408(k) plan, extending to small businesses of any size and self-employed individuals. Eligibility hinges on being at least 21 years old, having worked for the employer for a minimum of three out of the last five years, and receiving compensation of at least $650 from the employer (adjusted to $750 for 2023).
Annual employer contributions are capped at the lesser of 25% of the employee's pay or $69,000 for 2024, with the compensation limit set at incomes below $305,000 for 2022 ($330,000 for 2023). The maximum deduction allowable on a business tax return for contributions is determined by the lesser of the total contributions into employees' accounts or 25% of compensation.
Plan holders retain the flexibility to make withdrawals from their 408(k) plans at their discretion, similar to traditional IRAs, subject to certain conditions. Typically, withdrawals occur post the age of 59½, with any distributions before this age incurring a 10% early withdrawal penalty. Withdrawals are mandated as required minimum distributions (RMDs).
As mentioned earlier, a 408(k) plan stands as one type of employer-sponsored retirement plan, while the 401(k) plan emerges as the prevailing choice offered by the vast majority of American corporations.
The 401(k) plan enables taxpayers to contribute pre-tax funds via automatic payroll deductions, often supplemented by employer matches for participating employees.
Reforms to these plans have led to several beneficial changes for employees, including reduced fees and expanded investment options. The average 401(k) plan now offers over two dozen investment choices, tailored to balance risk and reward based on employee preferences.
Unlike a SEP, employees have the option to contribute to a 401(k) plan. Additionally, self-employed individuals or couples can opt for a solo 401(k) plan, featuring the same total contribution limits as employer-sponsored plans.
Participation in traditional 401(k) plans continues to increase steadily. By September 2022, these plans collectively held approximately $6.3 trillion in assets, representing more than half of the retirement market in the United States. As of the same period, there were 625,000 active plans across the country, benefiting a total of 60 million former employees and retirees.
In conclusion, the 408(k) plan stands out for its simplicity and tax advantages. Understanding its eligibility, contribution limits, and comparative analysis with other plans can equip individuals to make well-informed financial choices.
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