The 401(k) retirement plan is the most widely known and used employer-sponsored retirement plan. The 408(k) is another type of employer-directed retirement plan in which small business employees can participate. It is also called the simplified employee retirement plan (SEP-IRA). Both the 401(k) and the 408(k) refer to sections of the Internal Revenue Service Tax Code that explain what they are, how they work and who they are for. Let’s break down the key differences for your retirement.
A financial advisor could help you put a retirement plan together for your needs and goals.
What Is a 408(k)?
A 408(k) is a simplified employee pension plan commonly called the SEP-IRA. It is similar to a 401(k) and is, in fact, a simplified version of it. It is specifically for small businesses with fewer than 25 employees. Because the 408k is simplified, small businesses can afford to offer it. The 408(k) plan is allowed to take only employer contributions. Employees cannot contribute on their own. Instead, they specify a certain percentage of their salary, up to a maximum of $58,000 annually, and the employer invests that out of their gross pay and before taxes. The employee is vested in the plan immediately. The employee has the power to determine the asset allocation in their 408(k).
If the business has a year when profitability is down, for example, it does not have to make contributions to the 408(k)s of the employees. However, the contributions are tax-deductible by the business and there are no taxes on the investment earnings. Most types of business can have a 408(k), including sole proprietorships, partnerships, corporations and S-corporations. Employees can also contribute to other retirement accounts.
Small business employees have to meet certain qualifications in order to participate in their company’s 408(k) plan. They are:
- You have to be at least 21 years old.
- You must have worked at the company the last three out of five years.
- You must have earned at least $650 from the company during both 2021 and 2022.
- You cannot be covered by a union retirement plan and still participate.
- You can’t be a nonresident or alien employee.
408(k) vs. 401(k): Which Is Better for Your Retirement?
There are several characteristics of these two plans that determine which one may be best suited for your retirement. These include who can contribute, limits of contribution, control of each account’s holdings, contribution deadlines and early withdrawal penalties. Be sure to weigh these carefully as you decide which plan is most appropriate for your needs.
Contribution sources for a 408(k)
The SEP-IRA or 408(k) was authorized by Congress in 1978 to provide small businesses the opportunity to establish a retirement plan similar to the 401(k). One of the key differences between the 408(k) and 401(k) is that, for the 408(k), only employers can contribute rather than employees. Each eligible employee must receive the same percentage from the employer. The employer can also contribute a matching contribution. If you are both the employer and employee in a small firm, like a consulting or freelance firm, you can still, as the employer, set up the 408(k) and contribute a portion of your salary to it for yourself. If you have a 401(k), you make the contributions up to yearly limits from your salary and your employer may or may not match it.
Depending on how the 408(k) is set up, sometimes employees can make contributions much like the 401(k). One of the advantages of the 408(k) is that the contribution limits are higher than for a traditional IRA and it varies how they compare to the 401(k). For 2021, the contribution limit is the lesser of 25% of the employee’s salary and $58,000. For 2022, the limit is $61,000. This does not include the catch-up contribution of $1,000 for anyone age 50 and older. The 401(k) has a maximum contribution of $19,500 for 2021 and $20,500 for 2022. The catch-up contribution for both 2021 and 2022 is $6,500 if you are 50 years of age or older.
For a 408(k), regardless of salary, the annual contribution limits upon which a contribution can be made are $290,000 in 2021 and $305,000 in 2022. The limits are the same for 401(k)’s.
Level of control
If you are enrolled in a 401(k), you may not have complete control of your asset allocation. You will have a limited choice of funds. If you are in a 408(k), you do have complete control of the securities you choose for your portfolio. This saves you the administrative costs of a 401(k). When you are choosing your portfolio, you may want to employ the services of a financial advisor or you may want to do it yourself. Approach this with caution. The cost of a visit with a financial advisor may be worth it in terms of risk.
Contribution deadlines, early withdrawal penalty
The 408(k) has the same contribution deadlines as a traditional IRA. For the tax year 2021, the deadline is April 15, 2022, or October 2022 if you filed for an extension. For a 401(k), the contribution deadline is Dec. 31, 2021, the end of the tax year. Both the 401(k) and the 408(k) have a 10% penalty if you withdraw money before the age of 59 1/2.
The 408(k) or SEP-IRA is the comparable employer-sponsored retirement plan to the 401(k), but it is targeted at businesses with under 25 employees where the 401(k) is more appropriate to larger businesses due to the higher administrative costs. The 408(k) is meant to be a simplified employee retirement plan with less administrative cost. There are many similarities between the two types of tax-advantaged retirement accounts, but differences as well.
Retirement Planning Tips
- If you need help in choosing investment securities for either your 408(k) or 401(k), a financial advisor could help you create a retirement plan to reach your goals. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to determine how much investing in a 401(k) can help you in retirement, SmartAsset’s 401(k) calculator will break down an estimated value over time.
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