What it means
The design point is simplicity. Instead of a trust, a plan document running to hundreds of pages and annual compliance testing, the employer signs a short agreement, opens an individual retirement account for each eligible person, and pays contributions straight into them.
Contributions are discretionary year by year, which is why owners of lumpy businesses like the arrangement. In a strong year the employer can contribute generously, and in a weak year it can contribute nothing at all without penalty, something a defined benefit promise does not permit.
The central fairness rule is uniformity: the employer must contribute the same percentage of pay for every eligible employee, including the owner. That makes the cost easy to model, but it also means an owner cannot fund a large personal contribution without funding the staff at the same rate.
Eligibility turns on age, years of service with the employer and a minimum level of earnings, with the thresholds set in the tax rules and revised from time to time. Contributions are limited both as a percentage of each person's compensation and by an overall dollar ceiling that the tax authority updates annually.
Money in the accounts belongs to the employee immediately, with no vesting schedule to work through, and it grows free of tax until withdrawal. Older salary reduction versions of the arrangement are closed to new employers, which is why most current references to 408(k) mean a straightforward employer-funded SEP.
In practice
Real-world examples.
Example
A two-partner dental practice with four staff sets up a SEP under 408(k) and contributes 8% of pay in a profitable year, then nothing at all in the year it refits the surgery. Nobody is penalised for the pause, and that flexibility is exactly why the partners chose it over a scheme with fixed obligations.
Example
A freelance consultant earning $140,000 opens a one-person SEP and contributes from business profits, reducing taxable income and building retirement savings in a single step. Her accountant confirms the figure before the business tax return is filed, since the deduction and the contribution must agree.
Example
A growing agency with 20 employees outgrows its SEP because staff want to save from their own salaries as well. The firm moves to a 401(k) arrangement for future years and leaves the SEP accounts already funded in the employees' own names.
Formula
Calculation
Contribution per employee = eligible compensation x the uniform contribution percentage, subject to the statutory percentage and dollar limits.
A design studio with three eligible people settles on a 10% contribution for the year. Pay is $80,000 for the owner, $60,000 for a senior designer and $45,000 for a junior designer, a total eligible payroll of $185,000. The contributions are $80,000 x 10% = $8,000, $60,000 x 10% = $6,000 and $45,000 x 10% = $4,500, a total cost of $8,000 + $6,000 + $4,500 = $18,500, which matches $185,000 x 10% exactly. The owner cannot take an $8,000 contribution while giving the others 2%, because the percentage has to be the same for everyone.Case study
Seen in the real world.
Fernwood Surveying is a fictional firm used here as an illustrative example. The two owners drew $95,000 each, employed three surveyors on about $55,000 each, and wanted a tax-efficient way to save in a year when profits jumped.
Their adviser modelled a 15% SEP contribution. For the owners that meant $95,000 x 15% = $14,250 each, and for the three staff $55,000 x 15% = $8,250 each, so the total cost came to $14,250 x 2 + $8,250 x 3 = $53,250, all deductible against profits.
In the illustrative story the owners initially asked whether they could contribute 15% for themselves and 5% for the staff. The uniform percentage rule ruled that out, and they settled on 12% for everyone the following year when profits were lower, which is the kind of annual decision this arrangement is built to allow.
Watch out
Common mistakes.
- Assuming employees can pay into a 408(k) SEP out of their own salaries, when new arrangements of this type are funded by the employer only.
- Contributing a high percentage for the owner and a lower one for staff, which breaks the uniform percentage rule and can disqualify the arrangement.
- Quoting a fixed contribution cap from memory, when the dollar ceiling is set by the tax authority and revised periodically.
Questions
People also ask.
Is a 408(k) plan the same thing as a SEP IRA?
In everyday use yes; 408(k) is the statutory reference and SEP is the name the arrangement trades under.
Can an employer skip a year entirely?
Yes, contributions are discretionary each year, which is the main attraction for businesses with volatile profits.
Does the employee own the money straight away?
Yes, SEP contributions are immediately vested in the employee's own retirement account, with no waiting period before ownership passes.
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