Understanding the Power of 408(k) Plans
The term 408(k) account symbolizes an employer-sponsored retirement savings plan that grants employees the ability to put aside pretax dollars for retirement. These funds grow on a tax-deferred basis, making it a specialized form of individual retirement account (IRA). Taxes are only paid upon withdrawals post the age of 59½, offering significant deferred tax advantages. Often, this plan is synonymous with a simplified employee pension (SEP) plan—a parallel version of the widely known 401(k) plan.
Key Insights into 408(k) Plans
- Employer-Sponsored: A 408(k) plan is akin to a 401(k) and is facilitated by employers.
- SEP Plan: Also called a simplified employee pension, a type of IRA providing tax-deferred growth.
- Eligibility: Open to companies of any size and self-employed individuals subject to similar contribution limits as employers.
- Employer Contributions: Exclusively funded by employers, adhering to IRS limits on contributions.
- Contribution Caps: Contribution limits are set by the IRS to help regulate input levels by employers.
Qualifications for 408(k) Plan Participation
Section 408(k) of the Internal Revenue Code outlines guidelines for SEP and salary reduction simplified employee pension (SARSEP) accounts. Participants must meet certain criteria, such as:
- Being over the age of 21.
- Having worked for at least three of the last five years for the employer.
- Receiving compensation of at least $750 from the employer for 2023 (increased from $650 in 2022).
Employer Contribution Details
Annual contributions by employers must not exceed the lesser of 25% of the employee’s compensation or $66,000 for 2023. Employers can’t calculate contributions on earnings surpassing $330,000 (2023). Furthermore, deductions on business tax returns are limited to the total of the employee contributions or 25% of total compensation.
Withdrawal Rules
Withdrawals can be made at any time, akin to traditional IRAs. However, early distributions (before age 59½) incur a 10% penalty. Required minimum distributions (RMDs) must start by April 1 following the year one turns 73, starting January 1, 2023. Notably, SEPs carry advantages such as avoiding hefty startup or administrative costs.
408(k) Plans vs. 401(k) Plans: A Comparative Insight
While both are employer-sponsored, 401(k) plans are more prevalent and come with both employer and employee contributions, unlike SEPs that are solely employer-funded. Here are some comparisons:
Highlights of the 401(k) Plan
- Contribution Limits: Indexed to inflation, with caps at $22,500 for 2023, and additional catch-up contributions allowed for those aged 50+.
- Early Withdrawals: Similar penalty structures to 408(k), but include additional tax benefits.
- Market Growth: Holding roughly $6.3 trillion in assets and representing over half of the U.S. retirement market by end of September 2022.
- Investment Options: Expanded to include approximately two dozen diverse investment choices balancing risk and reward.
401(k) plans continue to dominate the U.S. retirement landscape, becoming a bedrock of financial security for millions.
Corrected Insight
Earlier misconceptions labeled 408(k) plans as exclusive to companies with 25 or fewer employees—posals to foundation size, open to any size of companies.
With insightful definitions and comparisons, both seasoned financial enthusiasts and newcomers can now connect with the transformative opportunities 408(k) Plans bring to the horizon.
Related Terms: 401(k) plans, traditional IRA, Roth IRA, self-employed retirement plans, IRS regulations.
References
- Office of the Law Revision Counsel. “U.S. Code: Title 26, Subtitle A, Chapter 1, Subchapter D, Part 1, Subpart A, § 408(k)”.
- Internal Revenue Service. “Simplified Employee Pension Plan (SEP)”.
- Internal Revenue Service. “Retirement Topics — Required Minimum Distributions (RMDs)”.
- U.S. Congress. “H.R.2617 - Consolidated Appropriations Act, 2023”, Division T: Title I: Section 107.
- Fidelity. “SEP IRA: Plan Details”.
- Fidelity. “Fidelity Advantage 401(k): Pricing Overview”.
- U.S. Department of Labor. “FAQs About Retirement Plans and ERISA”, Page 2.
- Vanguard. “How America Saves 2022”, Page 54.
- Internal Revenue Service. “401(k) Plan Overview”.
- Investment Company Institute. “401(k) Resource Center”.
- Internal Revenue Service. “Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits”.
- Internal Revenue Service. “Retirement Topics - Exceptions to Tax on Early Distributions”.
