A 408(k) Plan is a type of retirement savings arrangement established by employers to help their employees save funds for their retirement years. This plan derives its name from the specific section of the Internal Revenue Service (IRS) code that outlines its provisions. While there are some differences, the 408(k) Plan is essentially a simplified version of the popular 401(k) plan. These plans are specifically tailored for smaller businesses with fewer than 25 employees, and they are also available to self-employed individuals. The 408(k) Plans are alternatively referred to as SEP (Simplified Employee Pension) plans.
There are some restrictions on these plans. They are intended for self-employed individuals and small companies, and cannot be used by larger companies with more than 25 employees. Employees cannot exceed the annual contribution limits; if they do, the excess is taxed and penalized at 10%. Early withdrawals before retirement age are also subject to taxes and penalties, with an exception for loans, provided they are repaid according to a schedule set by the plan administrator. If the loan is not repaid, it is treated as an early withdrawal, incurring taxes and a 10% penalty on the loan amount.
One of the key advantages of the 408(k) Plan is that employees can contribute pre-tax dollars, which not only aids in saving for retirement but also reduces their taxable income for the year, potentially lowering their tax bracket. The contributions are only taxed when employees withdraw the funds during retirement. Employers can also make contributions to the employees’ accounts, which are tax-deductible for the employer, thus providing a valuable benefit for employees and saving the company on its annual tax bill.
Employers also have the option to make contributions to these accounts on behalf of their employees. These employer contributions offer dual benefits: they serve as an attractive employee benefit and provide tax deductions for the company. Despite being established by employers, these accounts remain the property of the employees and are maintained solely for their benefit.
Although employers set up these accounts, they are held in the employees’ names for their sole benefit. The 408(k) plans share several characteristics with 401(k) plans, but they are generally easier to comprehend, establish, and manage. Both types of plans have annual contribution limits set by the IRS. In both cases, employees enjoy tax-free treatment of employer contributions to their accounts. Additionally, both are tax-deferred accounts, meaning that taxes are only due when distributions are taken at retirement age, which begins at 59 and a half years old. Until that point, the contributed funds are not treated as taxable income.
Early withdrawals from these accounts (before reaching retirement age) are subject to both taxes and a 10% penalty. An exception to this rule allows employees to borrow from their accounts without penalties in cases of financial necessity. However, these loans must be repaid according to a schedule established with the plan administrator. Failure to repay the loan results in the borrowed amount being treated as an early withdrawal, subject to full taxation and the 10% penalty.
The IRS adjusts the maximum contribution limits for the 408(k) Plans periodically to account for inflation. When employees reach the age of 50, they can make larger catch-up contributions to compensate for any missed contributions over the years.
The maximum contribution limits for 408(k) Plans are subject to periodic adjustments by the IRS to account for projected inflation. Additionally, when employees reach the age of 50, they become eligible for higher annual contribution limits. This provision is designed to help older workers “catch up” on retirement savings they may have missed in earlier years.
