What is a 408(k) plan (SEP)?
A 408(k) plan is the Internal Revenue Code section that governs Simplified Employee Pensions (SEPs). A SEP is an employer-established retirement account that uses individual retirement accounts (IRAs) to hold plan assets. Employers make contributions to employees’ SEP IRAs; those contributions grow tax-deferred and are taxed when distributions are taken in retirement.
Quick definitions
– SEP (Simplified Employee Pension): an employer-based retirement arrangement where the employer contributes to employees’ IRAs.
– IRA (Individual Retirement Account): a tax-advantaged account used to save for retirement.
– Pretax contribution: money contributed before income tax is applied; taxes are paid when funds are withdrawn.
– Tax-deferred: investment growth is not taxed until withdrawn.
– RMD (Required Minimum Distribution): minimum withdrawals the IRS requires from some retirement accounts after a specified age.
How SEPs (408(k) plans) work — essentials
– Who can use them: SEPs are available to businesses of any size, including sole proprietors and self-employed individuals. Employers establish the plan and make all contributions.
– Employee eligibility: employers must follow the plan’s eligibility rules as required by IRC §408(k) (examples include service and compensation thresholds).
– Contribution limit (recent years): employer contributions cannot exceed the lesser of (a) 25% of an employee’s compensation, or (b) a fixed annual dollar cap — $61,000 for 2022 and $66,000 for 2023. Compensation taken into account is capped ($305,000 for 2022; $330,000 for 2023).
– Employer tax deduction: the business can generally deduct contributions up to the lesser of total contributions made or 25% of compensation.
– Withdrawals: distributions are treated like traditional IRA withdrawals — taxable when taken. Withdrawals before age 59½ generally incur a 10% early-distribution penalty, unless an exception applies.
– Required distributions: RMD rules apply. If you reached age 72 on or before Dec. 31, 2022, RMDs start by April 1 of the year after you turn 72. If you reach 73 on or after Jan. 1, 2023, you must begin RMDs under the updated timetable.
– Administration: SEPs are typically simple to set up and have lower administrative costs than many employer retirement plans.
How a SEP differs from a 401(k)
– Contributions: SEP contributions are made by the employer only; employees do not make salary-deferral contributions. By contrast, 401(k) plans allow employees to defer part of their salary and often include employer matching.
– Complexity and cost: SEPs are usually simpler and cheaper to operate than full 401(k) plans.
– Investment choice and plan features: 401(k) plans commonly offer many investment options and employer features (loan provisions, Roth options, automatic enrollment) that SEPs generally do not.
– Solo options: self-employed people may also use a solo 401(k); contribution rules and total limits can be comparable to employer 401(k) plans.
Short checklist: Is a SEP (408(k)) right for your business?
– Confirm you, as employer, are prepared to make contributions for eligible employees.
– Verify employee eligibility rules you will apply (service length, age, compensation thresholds).
– Calculate contribution capacity: will your business afford 25% of compensation for eligible staff up to the annual cap?
– Consider administrative burden: SEPs are low-cost and simple versus traditional 401(k)s.
– Review distribution rules and RMD timing so employees understand tax and timing consequences.
– Consult tax or retirement-plan counsel to adopt a compliant plan document and to ensure proper reporting and deductible treatment.
Worked numeric example (simple employee case)
Assumptions:
– Year: 2023
– Employee gross compensation: $100,000
– Employer contribution limit: lesser of 25% of compensation or $66,000 (2023 cap)
Calculation:
– 25% of $100,000 = $25,000
– Annual cap = $66,000
– Employer can contribute up to $25,000 for this employee in 2023 (because $25,000 is less than $66,000).
Tax consequence:
– The $25,000 contribution grows tax-deferred inside the employee’s SEP IRA and will be taxed as ordinary income when withdrawn in retirement. Early withdrawals before age 59½ may incur a 10% penalty in addition to income tax.
Notes and assumptions
– Contribution rules for self-employed individuals involve special calculations tied to net earnings; the simple percentage example above assumes a standard W-2 employee.
– Dollar limits and age thresholds cited reflect legislative and IRS guidance for the years noted; these limits change periodically.
Relevant official sources
– Office of the Law Revision Counsel — U.S. Code §408(k): https://uscode.house.gov/view.xhtml?req=granuleid:USC-prelim-title26-section408&num=0&edition=prelim
– Internal Revenue Service — Simplified Employee Pension Plan (SEP): https://www.irs.gov/retirement-plans/simplified-employee-pension-plan-sep
– Internal Revenue Service — Retirement Topics: Required Minimum Distributions (RMDs): https://www.irs.gov/retirement-plans/retirement-topics-required-minimum-distributions-rmds
– U.S. Congress — H.R.2617, Consolidated Appropriations Act, 2023 (relevant for recent limit changes): https://www.congress.gov/bill/117th-congress/house-bill/2617
Educational disclaimer
This explainer is for general information and education only; it is not personalized tax, legal, or investment advice. Rules and limits change over time. Consult a qualified tax professional or retirement-plan advisor to apply these rules to your specific situation.