What Is a 408(k) Plan?

A 408(k) plan is a type of retirement savings arrangement defined under Section 408(k) of the Internal Revenue Code. It is specifically designed for small businesses and self-employed individuals and represents a simplified employee pension (SEP) plan structure that functions similarly to a traditional individual retirement account (IRA). These plans allow employers to contribute to retirement accounts for their employees without the administrative complexity of more formal qualified plans like 401(k)s. The 408(k) structure is most often used in the context of SEP-IRAs, particularly in businesses with few employees.

Legal Foundation and Plan Type

The name "408(k)" refers to the subsection of the Internal Revenue Code that governs this type of plan. It falls under the broader category of simplified employee pension plans, commonly known as SEP plans. A 408(k) plan is not a qualified plan under ERISA’s Title I rules in the same way a 401(k) is, but it does meet certain qualification requirements under Section 401(a), giving it favorable tax treatment.

Because the plan uses traditional IRAs as the funding vehicle, it is not a stand-alone retirement account. Instead, it is an employer-sponsored arrangement where each eligible employee receives contributions into a separate IRA established under the plan. These are often referred to as SEP-IRAs.

Eligibility and Participation Requirements

408(k) plans have minimal eligibility restrictions, making them accessible to most employees within a business. Generally, employees must be at least 21 years old, have worked for the employer in at least three of the past five years, and have earned at least a minimum dollar amount (adjusted annually by the IRS) in compensation.

Employers may choose less restrictive eligibility rules, but they cannot impose more restrictive criteria than those set by the IRS. Notably, certain employees may be excluded from participation, such as those covered by a collective bargaining agreement, nonresident aliens with no U.S. income, or employees earning below the compensation threshold.

Employer Contributions and Limits

One of the defining features of a 408(k) plan is that all contributions are made by the employer; employees cannot defer salary into the plan. The employer makes discretionary contributions to each eligible employee's SEP-IRA. Contributions must be made equitably, following one of two standard formulas: either a fixed percentage of compensation for all participants or a dollar-for-dollar allocation within the annual limits.

The maximum contribution an employer can make is subject to IRS limits, which are the lesser of 25% of an employee’s compensation or a fixed dollar amount (e.g., $66,000 in 2023; this amount is indexed annually). Contributions are tax-deductible for the employer and tax-deferred for the employee until distribution.

Tax Treatment and Filing Requirements

408(k) plans offer favorable tax treatment for both employers and employees. Contributions are tax-deductible for the business, and employees do not pay taxes on contributions or investment earnings until they take withdrawals, typically during retirement. Withdrawals are taxed as ordinary income, and early distributions (before age 59½) may be subject to an additional 10% IRS penalty unless an exception applies.

One of the reasons 408(k) plans are popular among small businesses is the reduced administrative burden. There is no requirement to file annual reports (such as Form 5500), and the setup process is relatively simple. Employers must complete IRS Form 5305-SEP unless a prototype SEP document is used through a financial institution or advisor.

Required Distributions and Vesting

Like traditional IRAs, SEP-IRAs under a 408(k) plan are subject to required minimum distributions (RMDs), which must begin by April 1 of the year following the year in which the account holder turns age 73 (or 72 for those born before 1951, subject to changes in legislation). All contributions made to the plan are 100% vested immediately, meaning employees have full ownership of the funds regardless of how long they remain with the employer.

Special Case: 408(k)(6) SARSEP

Prior to 1997, employers could establish a Salary Reduction Simplified Employee Pension plan, or SARSEP, under Section 408(k)(6), which allowed employee elective deferrals similar to a 401(k). However, the Small Business Job Protection Act of 1996 prohibited new SARSEP plans after December 31, 1996. Existing SARSEPs were grandfathered in and may still be used if they continue to meet eligibility and nondiscrimination requirements, but no new SARSEPs can be established.

SARSEPs required that at least 50% of eligible employees elected to make salary deferrals and were subject to additional rules to ensure fairness in contribution levels. Today, 408(k) plans refer primarily to SEP-IRAs without salary deferral features.

Use Cases and Limitations

A 408(k) plan is best suited for small businesses, sole proprietors, and partnerships seeking a low-cost, tax-advantaged way to contribute to retirement savings for themselves and their employees. Its administrative simplicity, immediate vesting, and flexible contribution rules make it appealing for employers who do not want to manage the complex testing or filing requirements associated with 401(k) plans.

However, the plan does not allow for catch-up contributions or Roth contributions, nor does it permit employee deferrals (outside of grandfathered SARSEPs). It is less flexible in plan design compared to a 401(k), especially in businesses with younger, high-turnover staff who may not meet the eligibility thresholds.

The Bottom Line

A 408(k) plan is a streamlined retirement plan option created for small employers that enables tax-deferred contributions into employee IRAs with minimal administrative burden. It provides immediate vesting and straightforward eligibility rules, but it lacks the salary deferral and customization features found in more complex plans. For many small business owners seeking an efficient and compliant way to offer retirement benefits, the 408(k) SEP-IRA remains a practical and widely used solution.