Alternate name: Simplified Employee PensionAcronyms: SEP, SEP IRA
For example, let’s say you run a freelance writing business as a sole proprietor. You decide to open a SEP IRA through an online brokerage, which requires completing a simple online form. Once your 408(k) plan is open, you can contribute money up to the IRS annual contribution limits to fund your retirement.
How a 408(k) Plan Works
Businesses of any size can establish a Simplified Employee Pension or 408(k), though they may appeal more to smaller businesses for two reasons. First, a 408(k) plan is typically easier to establish than a 401(k) plan. Companies can create one by adopting IRS Form 5305. Second, 408(k) plans can be easier to maintain and administer, as there are no filing requirements for employers, and overhead costs tend to be lower. A 408(k) plan is not the same as a 401(k) in terms of how contributions work and the guidelines for establishing these plans. While a business of any size can set up a 408(k), not all employees can contribute. Employees are eligible if they:
Are at least 21 years of ageHave worked for your business in three of the last five yearsReceived at least $650 in compensation from your business (as of tax year 2021)
These eligibility requirements apply to all plan participants, including the plan owners. Businesses can exclude employees who are:
Covered by a union agreement if retirement benefits were bargained for in good faith by you and the employees’ union ORNonresident aliens with no U.S. source of compensation
You could also choose to exclude employees who don’t meet the above-mentioned requirements for age, years of service, or compensation. Only employers make contributions to a 408(k). For 2022, employers can contribute 25% of the employee’s compensation or $61,000—whichever is lesser. If you have employees, you can use the following types of compensation to determine contributions:
Wages, tips, and other compensation subject to income tax withholding under section 3401(a) Amounts described in Internal Revenue Code Section 6051(a)(8) Compensation deferred under a 457 plan
The maximum compensation limit that can be used for these calculations in tax year 2022 is $305,000. Your net earnings from self-employment are used to determine what you can contribute. Specifically, it’s based on earnings from self-employment minus one-half of your self-employment tax and contributions to your SEP IRA. For example, say you’re a sole proprietor and for tax year 2021, you had net earnings from self-employment of $150,000. You could have contributed a maximum of $27,881 to a 408(k) plan for tax year 2021. A 408(k) or SEP IRA follows the withdrawal rules as traditional IRAs do. That means you’ll pay ordinary income tax on the money you withdraw. And withdrawals made before age 59 ½ may be subject to a 10% early withdrawal penalty.
408(k) Plan vs. 401(k) Plan
A 408(k) plan and a 401(k) plan offer two very different approaches to saving for retirement. Both can offer advantages to employees as well as employers, though there may be some disadvantages to consider, as well. A 408(k) plan may also offer different investment options than a 401(k). Here’s a breakdown of how these plans compare side by side.
