408(k) Plan: What It Is and How It Compares to a 401(k)

Key takeaways

• A 408(k) plan is the simplified employee pension (SEP) version of an individual retirement account (IRA) sponsored by an employer.
• Only employers (including self-employed business owners) may contribute to a 408(k)/SEP IRA; employees do not make salary-reduction contributions.
• Employer contributions are tax-deferred and subject to IRS limits.
• SEPs are simple to set up and have lower administrative costs than many traditional employer plans.
• A 401(k) allows employee pre-tax contributions, employer matches, and typically more investment choice; it’s the more common option for larger employers.

What is a 408(k) (SEP) plan?

A 408(k) plan—commonly called a SEP IRA—is an employer-sponsored retirement arrangement that lets employers make tax-deferred contributions to individual retirement accounts for eligible employees. Contributions grow tax-deferred and are taxed when distributions are taken in retirement. SEPs are widely used by small businesses and self-employed individuals because they’re easy to administer.

Who is eligible?

Employers must follow uniform eligibility rules. Typical requirements include:
* Age: generally over 21.
Service: worked for the employer for at least three of the last five years.
Compensation: met a minimum compensation threshold set by the IRS (for example, $650 for 2022 and $750 for 2023).

Employers may set broader (but not narrower) eligibility rules.

Contribution rules and limits

• Employer-only contributions. Employees cannot make salary-deferral contributions to a SEP.
• Contribution limit: the lesser of 25% of an eligible employee’s compensation or a dollar cap (for example, $61,000 for 2022 and $66,000 for 2023).
• Compensation cap for calculating contributions: e.g., $305,000 for 2022 and $330,000 for 2023.
• Business tax deduction: the employer’s deductible contribution is limited to the lesser of total contributions made or 25% of compensation.

Note: Limits are indexed periodically; check current IRS guidance for the latest numbers.

Withdrawals, penalties, and RMDs

• Withdrawals are treated like traditional IRA distributions and are taxable.
• Early withdrawals (before age 59½) generally incur a 10% additional tax unless an exception applies.
• Required minimum distributions (RMDs) must begin based on the RMD rules in effect for your birth year: those reaching age 72 by Dec. 31, 2022 followed prior rules; SECURE Act 2.0 increased certain RMD ages (for example, to 73 for people who reach that age on or after Jan. 1, 2023). Always confirm current RMD rules.

How a 408(k)/SEP differs from a 401(k)

• Contributions:
• 408(k)/SEP: only employer contributions.
• 401(k): employees can make pre-tax (or Roth, if offered) salary-deferral contributions; employers may match or make nonelective contributions.
• Administrative complexity and cost:
• SEP: simple to establish and maintain, minimal administration.
• 401(k): generally more administrative requirements, fiduciary responsibilities, and potentially higher costs (though larger plans may negotiate lower fees).
• Participant features:
• 401(k) plans commonly offer more investment choices, automated payroll deferrals, loans (if the plan permits), and catch-up contributions for older workers.
• SEP accounts are individual IRAs owned by each employee, so investment options depend on the custodian.
• Self-employed options:
• Solo 401(k): available to self-employed individuals (and spouses) and can permit both employer and employee contributions, often allowing higher total contributions than a SEP in some situations.

When to choose a 408(k)/SEP vs. a 401(k)

Choose a SEP (408(k)) if:
* You run a small business or are self-employed and want a low-cost, low-administration way to make employer-only contributions.
* You prefer flexible annual contribution amounts that can vary by year.

Choose a 401(k) if:
* You want employees to be able to make salary-deferral contributions (including Roth or catch-up contributions).
* You plan to offer employer matching and want richer participant features or broader investment menus.

Bottom line

A 408(k) (SEP IRA) is a simple, employer-funded retirement vehicle suited to small businesses and self-employed taxpayers who want straightforward, flexible employer contributions and low administrative overhead. A 401(k) offers more participant features and allows employee contributions, making it the more appropriate choice for employers seeking to encourage employee savings through payroll deferrals and matching. Check current IRS limits and rules when deciding which plan best fits your business and retirement goals.