When starting a new job, there may be multiple options for the type of retirement plans available to you. In most cases, you will have access to a 401(k) plan, but there are other possibilities as well. One of the other incentives a prospective employer may offer is participation in a profit-sharing plan, which splits a portion of the profits among eligible employees, generally either once a month or yearly. If you're faced with the possibility of both plans at your new job, you've probably been wondering what the differences are.
The biggest differences between a 401(k) and a profit-sharing plan lie in who contributes funds to those accounts. With a 401(k), the individual will be the primary contributor, often with the employer contributing funds. Under a profit-sharing plan, only the employer contributes.
While this difference may seem relatively straightforward, there are some other considerations to take into account when deciding which plan you may want to take part in. Some will find there is more incentive to have one or the other, while others may see benefits to having both, if available. We're going to take a close look at both 401(k) plans and profit-sharing plans and how each may affect your retirement.
How Does A 401k Work
A 401(k) plan is a retirement account that is generally opened and set up on your behalf by your employer, and it is named after the tax code section that created it. Until relatively recently, they were only available with an employer who worked with a broker to provide retirement accounts for all of their employees, which led to the exclusion of self-employed or freelance workers. This has evolved in recent years, however, and now many brokers offer a group solution to 401(k) plans that allow individuals to open and maintain their own retirement accounts.
In most cases, a 401(k) is structured as an investment portfolio, with investments in various securities that are pre-defined by the IRS. This means that no matter who provides the 401(k), the IRS limits what types of assets can be invested in and made part of the retirement portfolio. Most 401(k) plans are limited to investing in assorted managed funds, which are collections of investments in various companies. Mutual funds are a prime example of this, where each fund generally represents an investment in a group of companies within a similar market cap grouping or within a particular sector, like automotive, healthcare, or energy.
A 401(k) is a type of target-date fund, which means the fund changes once you approach your retirement age. With a 401(k) plan, this generally means that you can only contribute to the plan in younger years until you reach retirement age, commonly 55, at which point the fund changes to allow the employee to begin drawing on the fund. There are exceptions where early withdrawals can be made for hardships, though these are often heavily penalized with both taxes as well as early withdrawal penalties. That said, there are some limited situations where you may be able to withdraw limited funds early, without penalty.
Every 401(k) plan is tax-advantaged, which means that funds contributed to the plan are fully tax-deductible. This means you can use them to significantly reduce your taxable income in some cases since each dollar contributed is one less dollar of tax liability each April. This also means that while you won't pay taxes on funds contributed to your 401(k), you will be taxed on funds withdrawn from the 401(k), no matter when they're withdrawn.
Employers can also contribute to their employee's 401(k) plan, which is tax-deductible for the employer as well. In some cases, the employer will have a contribution matching incentive, allowing many employees to effectively double their contributions depending on the matching program. This also means that if there are matching incentives offered by the employer, failing to contribute to the 401(k) is seen as leaving free money on the table.
The only catch is that there are limits to how much the employee can legally contribute to their 401(k) plan in a year. These contribution limits apply to the 401(k) in different amounts based on the employee's age and whether or not there are employer contributions as well.
Max 401k Contribution
401(k) plans are governed by maximum contribution limits the IRS imposes. In 2022 an employee is permitted to contribute a maximum of 20,500 to their 401(k) plan if they are under age 50 at the end of the calendar year. If they are 50 or older at the end of the calendar year, they will be permitted to contribute an additional $6,500 in a "catch-up" contribution. If there is an excess of contribution funds during a particular calendar year, those funds must be withdrawn by April 15 of the following year. Excess fund withdrawals are not subject to early distribution penalties.
What Is A Profit-Sharing Plan
Just as a 401(k) plan is a tax-advantaged retirement account, and they are operated by the employer for the employees. They operate in a very similar way to a 401(k) in that they are a target-date fund in which the contributions are invested into relatively mainstream and risk-averse investment securities or assets. These may be mutual funds or similar low-risk investment vehicles.
Unlike a 401(k), however, the employee does not contribute to the profit-sharing plan. All contributions are made by the employer. The criteria under which the employer contributes are generally defined in the employment contract or agreement or in a separate profit-sharing agreement that the employee is given. While the employer is able to fully define how they want to manage their profit-sharing plan, the formula for contributions must be standardized and applied to all employees of the organization in a uniform manner. The decision cannot be different for different employees or determined in an ad hoc manner.
There are common formulae used when employers contribute to their profit-sharing programs. One common method is to contribute a set portion of all corporate profits to the profit-sharing plan. For example, they may choose to contribute 12% of all profits, which are then divided equally among all eligible employees. Another common method is for the employer to contribute a flat percentage rate of each employee's annual salary, for example, putting 7% of each eligible employee's yearly salary into their profit-sharing retirement plan.
In some cases, the employer can also contribute to the plans in company stock. In cases like this, the contribution value will be derived from the market value of the underlying assets at the time of contribution. The biggest thing to remember is that when it comes to profit-sharing, the individual cannot contribute; only the employer can contribute, and then only at predefined rates or amounts. Any company that participates in a profit-sharing plan must use the same contribution formula for each employee, and all employees must be included in the plan, with exceptions for a few special circumstances, such as new hires.
Profit-Sharing Plan After Leaving Company
Most people who participate in a 401(k) understand that they can be rolled over and transferred if they leave the company, but lots of people are less familiar with profit-sharing plans and how they work in the context of employment changes. In some cases, a profit-sharing plan can be cashed out or transferred, and in many other cases, the employee will not be able to access the plan if they leave before the plan is fully vested.
One of the biggest factors that govern the employee access to their profit-sharing plan is the requirements for becoming fully vested. The profit-sharing agreement outlined by the company when the employee was hired will generally detail how long it takes to become fully vested. In some cases, the employee will gain larger vesting each year until fully vested, while in other cases, they will need a certain number of years tenure before the fund is considered vested.
Another thing to consider is how much has already been contributed and when. If an employee has been given a profit-sharing plan as part of their compensation package, and they are subsequently terminated or resigns, the statement finalization dates will play a considerable role. If they leave the organization in the fiscal year prior to when the finalization occurs, they will only be entitled to the amount contributed to their profit-sharing plan up to the fiscal year in which they discontinued employment.
Understanding 401(k) vs. Profit-Sharing Can Mean A Big Difference To Your Retirement
Knowing the difference in how 401(k) plans and profit-sharing plans work is a vital part of being able to successfully save for retirement. This includes knowing who is responsible for contributions, what the limits to those contributions are, as well as how those contributions are used. If you have access to a 401(k), profit-sharing plan, or even both, make sure you have all the information you need to understand how to best prepare for your retirement.
Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.