The SEP and SARSEP accounts, also known as individual retirement accounts (IRAs) or individual retirement annuities, are governed by Section 408(k) of the Internal Revenue Code (IRC). This section outlines the rules and regulations for these types of retirement plans.
According to the IRC, small business owners with 25 or fewer employees and self-employed individuals may be eligible to participate in a 408(k) plan. To qualify, individuals must be over 21 years of age, have worked for the employer for at least three of the last five years, and have earned at least $650 from the employer.
Employer contributions to the plan cannot exceed 25% of the employee’s pay or $61,000 for 2022, and $66,000 for 2023. Additionally, the annual compensation limit cannot be calculated on incomes over $305,000 for 2022 and $330,000 for 2023. The maximum deduction on a business tax return for contributions is also limited to 25% of compensation or the total contributions into employees’ accounts.
Participants in a 408(k) plan can make withdrawals at any time, similar to traditional IRAs, but certain conditions apply. For example, withdrawals made before the age of 59 1/2 may incur a 10% early withdrawal penalty. Additionally, required minimum distributions (RMDs) must be made once the individual reaches 72, if they were that age on or before December 31, 2022, and as of April 1 if they turn 73 on or after January 1, 2023.
Difference Between 408(k) Plans vs 401(k) Plans
A 401(k) plan is a widely used employer-sponsored retirement savings plan, offered by many American corporations. It allows employees to make pre-tax contributions to the plan through automatic payroll deductions, with the option for employer matches. Recently, the 401(k) plan has undergone reform, resulting in lower fees and more investment options, with an average of nearly two dozen options available, tailored to an employee’s preferences. Unlike an SEP, employees and self-employed individuals who work for a company with a 401(k) plan can contribute to the plan.
Participation in 401(k) plans has continued to grow, with these plans holding approximately $7.7 trillion in assets by the end of 2021, representing about one-fifth of the retirement market in the United States. There were 600,000 active plans in the country, with a total of 60 million employees and retirees at the end of September 2021.
It’s important to note that contribution limits for 401(k) plans are indexed to inflation, and the Internal Revenue Service (IRS) allows employees to save up to $20,500 for 2022 and $22,500 for 2023. Catch-up contributions of $6,500 per year (increasing to $7,500 in 2023) are also allowed for people 50 or older. Withdrawals made before the age of 59 1/2 may result in a 10% early withdrawal penalty, unless an exemption applies. Additionally, taxes are imposed on any withdrawals made as contributions are made with pre-tax earnings. The SECURE ACT 2.0 has increased the age at which individuals are required to take RMDs from 72 to 73 for anyone who turns that age on or after January 1, 2023.