408k Plans

408(k) retirement plans offer a simple alternative to 401(k) plans for small businesses. They are available only to employers with 25 employees or fewer, and this group does include self-employed individuals. These plans are referred to as Simplified Employee Pension plans (SEP plans). The 408(k) name derives from the portion of the IRS code that deals with taxation of employee and employer contributions to the plan.

IRS Regulations

All employee contributions to a qualified 408(k) plan are tax deferred and tax deductible in the current year. The employee does not pay taxes on employer contributions. There is an annual contribution limit based on the employee's salary. This essentially means the employee can place pre-tax dollars, up to a given limit, in the account. At the end of the year, when the employee reports his or her income, this money is deducted from the income. The employee is taxed only once he or she removes funds from the account, and the tax rate equals the individual's tax rate at the time of withdrawal. Like 401(k) and other retirement plans, 408(k) accounts are "locked" until a qualified age. Withdrawing before the age of 59 1/2 results in a 10 percent penalty in addition to regular tax payments.

Employer Contributions

The main reason to use an SEP 408(k) qualified plan rather than an Independent Retirement Account is because the employer can make contributions to the account as well. With an IRA, the employee is independently managing his or her own retirement account. The 408(k) option allows the employee to receive benefits from his or her employer in terms of retirement savings. The employer can match employee contributions or provide a flat contribution--this is entirely up to the individual employer. The benefit to the employer, however, is that the employee manages the account himself or herself. The employer does not have to pay for 401(k) administration.

Setting Up a 408(k)

Your employer must be the one to initiate the setup of a 408(k) plan. The employer must have fewer than 25 employees. Further, the plan must be set up by December 30 in the year prior to the tax year when contributions will be deducted. The employer must provide notice to all employees regarding the rules and regulations for the plan. For example, a notice to employees should inform them of the SEP option, the amount the employer will contribute and which employees will be eligible.

Contributing to a 408(k)

If your employer offers this plan, you can make contributions on every paycheck up to a given limit. Your contributions will be immediately vested in the account. Your employer may match immediately or delay the matching until a later date, but this must be determined in the SEP plan documents. If you are self-employed, the manner in which you contribute funds will be important. You may either pay yourself a salary from your company and deduct contributions from the salary, or if your salary equals the profits of your company, you may deposit a portion of company profits. Limits will depend on which of these options you choose.