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What is a 408(k) Plan?

Money Manager | Wednesday, June 16th, 2010

408(k) Plan

There are numerous financial planning tools to choose from, but not all plans are able to be offered by every employer. There are restrictions and limits which must be followed, including the number of employees a company has. While many companies offer 401(k) plans for their employees, these are not always feasible for smaller companies. In these cases, there are other similar plans that can be offered, such as the 408(k) plan.

What are the basic features of a 408(k) plan?

A 408(k) is a plan that allows employees of smaller companies and those who are self-employed to save money for retirement. Although many people think the 408(k) term is the actual name of a plan, it is really a term that describes an Internal Revenue Code. This code defines and details the Simplified Employee Pension account, which is commonly referred to as an SEP account. These plans allow individuals to contribute to a retirement plan account using their pre-tax dollars. The use of pre-tax instead of after-tax dollars can effectively reduce an employee’s income for the year, which can result in significant tax savings for the individual. The employee and the employer can both contribute to this account, although the account itself is in the employee’s name. Although these plans have many features that are similar to a 401(k) plan and they are used for similar reasons, the 408(k) is actually a simpler plan. There are annual contribution limits for a 408(k) plan. However, the employee does not have to pay any taxes on the monetary contributions that the employer contributes to the account. All money that is contributed to a 408(k) account is tax deferred, which means that no taxes are paid until the money is withdrawn when the employee reaches retirement age. Any money which is contributed to one of these accounts is not considered as income, until the time of retirement. Although the employer maintains the 408(k) plan, the employee is actually considered to be the owner of the account.

What are the restrictions of a 408(k) plan?

Although the 408(k) plan is similar in many respects to the 401(k) plan, there are limits to when a company is able to offer the 408(k). Basically, this plan is limited to companies who have fewer than 25 employees. The 408(k) plan is also a retirement plan option which is available to individuals who are self-employed. 408(k) plans are controlled by the corresponding section of the Internal Revenue Code, which details the actual requirements and restrictions of these plans. Money cannot be taken from a 408(k) plan prior to retirement or before the person reaches the age of 59-1/2. When the employee reaches this age, the money in the plan is then considered to be regular income, and is therefore taxed at the person’s current taxable level. If necessary, the employee can take out loans on their 408(k) plan and then repay the amount. However, if the money is simply withdrawn and not taken out as a loan, a 10% penalty will be assessed, along with any taxes that would be due on the total amount that is withdrawn.

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