What Is a Profit-Sharing Plan?
A profit-sharing plan is a type of retirement plan in which an employer shares a portion of the company’s profits with eligible employees. These plans are typically discretionary, meaning the employer can decide how much to contribute to employees’ accounts each year based on the company’s profits and types of profit. Unlike a 401(k), in a profit-sharing plan, there are no employee contributions.
Eligibility requirements for plan participants may vary depending on the plan design, but most plans generally require employees to be at least 21 years old and have at least one year of service with the company.
Employers contribute to profit-sharing plans using a predetermined contribution formula, which can be based on a fixed percentage of profits or a more complex allocation method. Some popular profit-sharing plan formulas include: flat-dollar amount, pro-rata, new comparability, age-weighted, and Social Security integration.
Contributions are generally tax-deductible for employers, while employees defer taxes on profit-sharing contributions until they withdraw the funds in retirement.
What Is a 401(k) Plan?
A 401(k) plan is a tax-advantaged retirement account sponsored by an employer that allows eligible employees to save and invest a portion of their pre-tax income for retirement. Both employees and employers can contribute to a 401(k), with the option for employer matching programs.
401(k) plans are available to employees of private companies, government organizations, small businesses, as well as self-employed individuals, with various tax-deferred contribution options depending on business size and employment status.
Employees can make salary deferrals to their 401(k) accounts, which are then invested in a variety of investment options mutual funds, company stock, or in some cases, ETFs. Investment fees may apply and can vary depending on the plan.
Contributions to a traditional 401(k) plan are tax-deferred, meaning employees do not pay income tax on their contributions until they withdraw the funds in retirement. Employers may also receive tax deductions for their contributions to the plan, according to IRS policy.
Some 401(k) plans may allow for after-tax Roth contributions, but there is no requirement that post-tax deposits be allowed.
There is administrative maintenance involved for the employer, as they have to undergo nondiscrimination testing to prove their plan does not unfairly favor highly compensated employees.
How Does Vesting Impact a 401(k) or Profit-Sharing Plan?
Vesting refers to the process by which employees gain ownership of their employer’s contributions to their retirement accounts. Vesting schedules determine how long an employee must work for a company before they are entitled to the full value of the employer’s contributions to their retirement plan.
This can be either immediate or follow a graded or cliff vesting schedule, where employees gradually gain ownership over a period of time or become fully vested after a specific number of years. Vesting schedules can vary greatly from employer to employer.
Both profit-sharing plans and 401(k) plans come with varying vesting schedules. These schedules can vary based on plan design, and employers may set different vesting rules for their contributions to each type of plan.
With 401(k) plans, employee contributions are always 100% vested, meaning you’re always entitled to what you put in. Employer contributions, on the other hand, may be subject to a lengthy vesting schedule that will vary by employer.
With profit-sharing plans, since employees can’t contribute on their own, there is likely to be a vesting schedule for all monies contributed.
Comparison of Profit-Sharing Plans and 401(k) Plans
While both profit-sharing and 401(k) plans offer retirement benefits to employees, there are several key differences between the two, as well as areas of overlap:
- Eligibility requirements and employer contributions: Profit-sharing plans typically have more stringent eligibility requirements and are based on a company’s profits. Only employers can make contributions to profit-sharing plans. On the other hand, 401(k) plans allow for employee salary deferrals and, correspondingly, employer matching contributions.
- Contribution limits and investment options: Both profit-sharing and 401(k) plans have annual contribution limits set by the IRS. Many employers employ both types of plans. Investment options can vary greatly by employer and by plan sponsor, but usually consist of a mix between mutual funds and employer stock.
- Your employer can contribute up to the lesser of 25% of your employee compensation or an annual maximum of $66,000 to your profit-sharing plan. It has no obligation to contribute, but it can.
- You can contribute $22,500 to your 401(k) plan in 2023, with a $7,500 catch-up available for those 50 and over. Total contributions, including your employer’s, cannot exceed $66,000 ($73,500 with the catch-up).
- Vesting and distribution rules: Vesting schedules can vary between profit sharing and 401(k) plans, depending on the plan design. Distribution rules may also differ, with profit-sharing plans sometimes offering more flexible withdrawal options compared to 401(k) plans.
- Business owners running 401(k) plans must pass nondiscrimination tests to prove their plan doesn’t unfairly advantage highly compensated employees.
- Tax implications: Both plans offer tax benefits for employers and employees, but the specific tax advantages may differ based on the type of plan, contributions, and withdrawals. Generally speaking, contributions to profit-sharing plans and to 401(k)s are tax-deferred, meaning you’ll only be liable for income tax when you withdraw money — ideally in retirement.
Which Type of Plan Should I Choose?
Note that if you’re an employee, you won’t have control as to whether your employer chooses a profit-sharing plan or a 401(k), or both. This is at the discretion of your employer.
From the employer’s perspective, note that contributions to profit-sharing plans are purely discretionary, while employer matching contributions may be compulsory if noted in your 401(k)’s summary plan document.
Both accounts offer similar income tax advantages. Employees may appreciate the opportunity to contribute to 401(k)s, but they may also value employer-driven contributions in a profit-sharing plan.
Common Misconceptions About Profit Sharing Plans and 401(k) Plans
There are several misconceptions about profit-sharing plans and 401(k) plans, including misunderstandings about contribution limits, eligibility requirements, and investment options. Additionally, confusion over tax-deferred treatment of retirement funds may lead to incorrect conclusions about current-year tax liabilities.
Perhaps the most common misconception is that employees may think they can contribute to profit-sharing plans; as we’ve discussed, this is not the case.
Working with a knowledgeable financial advisor or fiduciary can help clarify these misconceptions and ensure you make an informed decision when selecting a retirement plan and understanding all the terms noted by plan administration providers.
In Summary
Profit-sharing plans and 401(k) plans both offer valuable retirement benefits, but their differences in eligibility requirements, employer contributions, and tax implications may impact your decision.
Whenever you have the opportunity to select a retirement plan, consider your financial goals, overall employer benefits, investment options, and retirement timeline.
If you’re looking for assistance rolling over a 401(k) to an IRA, Capitalize is the partner of choice.
Find out more about how Capitalize can manage an entire 401(k) rollover for free.
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