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What is a 408(k) Plan?

2016-11-18T10:33:22+00:00

The term '408(k) Plan' is included in the Investments edition of the Financial Dictionary. Get yours now on amazon in ebook or paperback format. Read more here...

The 408(k) Plan is a retirement plan that employers set up to assist their employees in saving money for their post working years. It is named for the section of the IRS code that describes these accounts. Though there are some distinctions, a 408(k) Plan is actually a simpler version of the ever popular 401(k) plan.

These 408(k)’s are intended for smaller companies which employ fewer than 25 staff. Self employed individuals are also able to take advantage of these plans. SEP Simplified Employee Pensions are another name for the 408(k)’s.

These plans are practical and useful for workers because they are able to contribute dollars that have not yet been taxed. In addition to helping them save for retirement, it lowers their net incomes for the tax year in question. This can reduce the tax bracket into which the employees fall. It leads to lower taxes for the individuals who contribute. The deposits do not become taxable as income until the point where the employees take their money back in the form of distributions.

Employers are also able to contribute funds to the account on behalf of the employees and in their names. The employer contributions are similarly tax deductible. Besides providing the employer with a nice benefit to offer their workers, it saves them on their annual company tax bill as well. Though these accounts are set up by employers, they remain in the name of the employees and for their sole benefits.

408(k) plans share many features with their 401(k) cousins. The 408(k)’s are somewhat simpler to understand, set up, and utilize. Both plans have yearly maximum contribution limits. With these plans, the employees also do not pay any taxes for contributions which the employer makes in the account. Both accounts are also tax deferred.

Taxes will only become due when the employee takes distributions at the retirement age starting at 59 and a half. Until that point, none of the money they contribute will be treated like income. 

There are some limitations and restrictions on these kinds of accounts. They can be utilized by self employed individuals and smaller companies. They may not be set up by larger companies which count more than 25 employees.

Employees can not contribute more than the maximum annual limit to these accounts. If they do, the surplus dollars will be treated as income, taxed, and also penalized by 10%. Money which an employee takes out early before retirement age is also subject to taxes and 10% penalties.

There is an exception to this early withdrawal rule. If an employee feels the financial need, he or she is allowed to take money back without penalties on a loan basis only. 408(k) plans do allow for such loans, provided that they are repaid. The money must be paid back to the account according to a payment schedule set up with the plan administrator. In the even that it is not put back, the loan amount becomes treated as an early withdrawal distribution. In this case, the full tax and 10% penalty amount will apply to the total loan principle.

The maximum contribution amounts to the 408(k) Plans vary by year. The IRS increases the limits from time to time to compensate for projected inflation. When employees reach 50, they are allowed to increase their contributions per year to an IRS allowed larger dollar amount. This is to help them to catch up on any contributions which they may have missed out on over the years.

The term '408(k) Plan' is included in the Investments edition of the Financial Dictionary. You can get your copy on amazon in Kindle or Paperback version. See more details here.