408k plans are more commonly known as "Simplified Employee Pensions" or SEPs. They're employment-based retirement plans whose key advantage for employers is that they're simplified, and thus have lower start-up and overhead costs when compared to traditional retirement plans. From the employees' perspective, the key benefits are instant vesting and the fact that the employer is responsible for making all the contributions.
Employers are allowed to contribute as much as 25% of an employee's salary to the plan on that employee's behalf, but no more than $53,000 for any given employee in 2015. Any employer contribution to your retirement plan can be a huge help, but a 408k plan with a strong contribution level can go a long way toward helping you retire comfortably.
In a typical 408k plan, employers (or their employees) set up special accounts, called SEP-IRAs, for each eligible employee. The employer makes all contributions to 408k plan accounts, and the employees are always immediately vested in the contributions. Employees are eligible if they:
- Are at least 21 years old,
- Have worked for the company for at least 3 of the past 5 years,
- Have earned at least $600 from the company in 2015,
- Are not covered by a separately negotiated union retirement plan, and
- Are not non-resident alien employees who have received no US sourced wages from the company
Companies can set more lenient guidelines for eligibility if they so choose, but not more restrictive ones.
A company with a 408k plan is not required to make contributions to the plan, but if it does, it needs to do so in a way that passes non-discrimination tests. That typically means for these types of plans that if the company does make contributions, each employee gets the same percentage of his or her salary contributed to the plan. All contributions to a 408k plan are "traditional" type contributions -- pre-tax dollars that grow tax-deferred while in the plan.
If you're self-employed, your 408k contribution limit is based on your net income from self-employment. As a result, you'll have to deduct half your self-employment tax and your 408k contributions themselves before determining how much you're eligible to contribute.
Are there any watch outs?
If your employer offers you a 408k style retirement plan, the key thing you need to be concerned about is whether your employer will be able to continue making sufficient contributions on your behalf. Contributions aren't mandatory, so companies that run into cash flow problems may cut back on their contribution levels when times are tough. Because all employees generally get the same percentage of their salary contributed, it may take a substantial recovery before a company that stops contributing resumes its contributions later.
Fortunately, even if your employer offers you a SEP-IRA 408k style plan, you still retain eligibility to make traditional or Roth IRA contributions on top of that. That holds true regardless of whether your employer actually contributes to the plan or not. In addition, you can always invest any available money you have in a traditional brokerage account and simply earmark that toward your retirement.
Additionally, since the SEP-IRA that your employer contributes to is yours, you will likely have more flexibility and choices in it than you would in a typical employer sponsored plan. If you have solid investing skills, that can be an incredible boon to you, as you'll be able to tailor your account's investments to your particular needs, risk tolerance, and life stage.
If you haven't yet developed solid investing skills, however, that flexibility and individual account ownership comes with its own risks. A key risk comes from the fact that your employer's obligation essentially ends when the contribution is made. As a result, you'll need to take an active role in the investing decisions. Otherwise, you face the risk that the money will simply pile up in cash within the account, rather than in an investment mix with the potential for legitimate positive returns.
A great foundation for your retirement
If your employer offers one or if you're self-employed, a 408k style retirement plan can provide a great foundation for your retirement. Just be sure that the contributions flow into your account and, once there, that you invest them in line with your plans, life stage, and risk tolerance. That way, you can build from that foundation and get that much closer to the retirement you've been dreaming of having.
Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.