What Is a 408(k) Plan and How Does It Work?
Learn how a 408(k) plan works, who can establish one, contribution limits, tax benefits, and key rules for withdrawals and distributions.
A 408(k) plan, also known as a Simplified Employee Pension (SEP) IRA, offers an alternative to traditional employer-sponsored retirement accounts by reducing administrative burdens while allowing for tax-advantaged savings. This plan is designed for businesses with fewer employees and provides flexibility in contributions.
Who Can Establish It
A 408(k) plan is a straightforward retirement savings option for sole proprietors, partnerships, and corporations, including S corporations. Unlike 401(k) plans, which require extensive reporting and compliance, SEP IRAs are easier to manage, making them ideal for small businesses.
Employers must offer the plan to all eligible employees—those at least 21 years old, who have worked for the employer in at least three of the last five years, and earned a minimum of $750 in compensation during the year (as of 2024). These requirements ensure broad participation.
Government entities and certain tax-exempt organizations cannot establish a 408(k) plan. However, sole proprietors with no employees can set one up, making it a viable option for freelancers, consultants, and independent contractors.
Contribution Limits
The IRS limits employer contributions to the lesser of 25% of an employee’s compensation or $69,000 for 2024. Compensation used to calculate contributions is capped at $345,000 for 2024 to prevent disproportionately large contributions for highly paid employees.
Only employers contribute to a 408(k) plan, and contributions must be allocated proportionally based on each employee’s earnings. Employers can adjust contributions annually based on profitability.
For self-employed individuals, contributions are based on net earnings after deducting business expenses and self-employment taxes. While the same 25% limit applies, the effective contribution rate is lower due to the adjusted income base.
Tax Implications
A 408(k) plan allows employers to deduct contributions as a business expense, reducing taxable income. Sole proprietors and self-employed individuals deduct contributions on their personal tax returns.
For employees, contributions are not taxable when deposited. Funds grow tax-deferred, meaning investment earnings are not taxed annually, allowing for greater compounding growth.
Employers must report contributions on their business tax returns. While a 408(k) plan does not require annual Form 5500 filings like a 401(k), businesses must comply with IRS reporting rules. Self-employed individuals use IRS Publication 560 to calculate their maximum allowable contribution. Exceeding contribution limits can result in a 10% excise tax if not corrected promptly.
Early Withdrawal and Penalties
Withdrawing funds before age 59½ generally incurs a 10% early withdrawal penalty in addition to ordinary income tax. For example, a participant in the 24% tax bracket who withdraws $20,000 early would owe $4,800 in income tax plus a $2,000 penalty, reducing their net distribution to $13,200.
Certain exceptions allow penalty-free withdrawals, though income tax still applies. These include total and permanent disability, unreimbursed medical expenses exceeding 7.5% of adjusted gross income (AGI), and distributions to beneficiaries after the account holder’s death. Other exceptions include withdrawals for higher education expenses, first-time home purchases (up to a $10,000 lifetime limit), and military reservists called to active duty for at least 180 days.
Distribution Requirements
At age 73 (as of 2024, per the SECURE 2.0 Act), individuals must begin taking required minimum distributions (RMDs). The IRS calculates the minimum withdrawal amount based on life expectancy tables. Failing to take the required amount results in a penalty—25% of the shortfall, though this can be reduced to 10% if corrected within two years.
Unlike Roth IRAs, distributions from a 408(k) plan are taxed as ordinary income. Retirees should plan withdrawals carefully to avoid moving into a higher tax bracket. Some roll funds into a traditional IRA before RMDs begin for more flexibility, while others use qualified charitable distributions (QCDs) to donate up to $100,000 annually to eligible charities, satisfying RMD requirements while excluding the amount from taxable income.
Administrative Obligations
Employers must follow administrative requirements, though these are simpler than those for traditional pension plans or 401(k)s. There are no annual Form 5500 filing requirements, reducing compliance burdens. However, contributions must be made consistently and fairly according to plan rules.
Recordkeeping is essential. Employers must track contributions, employee eligibility, and distributions to ensure IRS compliance. While financial institutions often handle much of the administrative work, business owners remain responsible for accuracy. Self-employed individuals managing their own plans must maintain detailed records of contributions and deductions. If a business undergoes structural changes, such as incorporation or dissolution, the plan may need to be amended or terminated, requiring proper documentation and participant notification.