Profit-sharing and 401(k) plans are both tax-advantaged retirement plans sponsored by companies. While the tax characteristics of both types of plans are similar, the way they are set up and managed is quite different. From the perspective of an employee, a 401(k) plan generally has more flexibility in terms of investments. A profit-sharing plan puts more control in the hands of employers.
Who Can Contribute
Profit-sharing plans only allow contributions from employers. Your employer is not required to make annual contributions on your behalf. However, if contributions are made, they must follow Department of Labor standards regarding fairness of allocation. Typically, this means that the percentage a business contributes to employee accounts must be roughly equal across all accounts. A 401(k), on the other hand, allows both employers and employees to make contributions. Many companies offer a matching program for 401(k) plans, in which the company will contribute a certain percentage of the amount that plan participants contribute.
Vesting is the process by which employees gain ownership over retirement plan contributions. You are always vested in your own contributions, but your employer may restrict your ownership of employer contributions for a period of time. The Department of Labor specifies two types of vesting schedules, known as graduated vesting and cliff vesting. In graduated vesting, you gain control over a certain percentage of employer contributions each year. The DOL requires vesting of at least 20 percent after two, 40 percent after year three and so on until you become 100 percent vested after year six. Cliff vesting allows employers to restrict vesting to zero percent for a period of three years, after which employees become 100 percent vested. Employers can offer a more rapid vesting schedule if they so desire.
The total contribution limit for both profit-sharing and 401(k) plans is the same, $50,000 as of 2012. However, the method by which this figure can be reached varies between plans. For a 401(k) plan, the maximum contribution you can make as an employee is $16,500 as of 2012, or 100 percent of your salary. If you are age 50 or older, you can contribute an additional $5,500. The remaining amount may be contributed by your company, as long as the total contributions do not exceed 100 percent of your salary. With a profit-sharing plan, total contributions cannot exceed the lesser of $50,000 or just 25 percent of your salary.
Distributions from all qualified plans, including 401(k) plans and profit-sharing plans, are taxable. However, while the money remains in the account, you don't have to pay tax on any of your earnings. In this category, profit-sharing and 401(k) plans are identical.
Both profit-sharing and 401(k) plans restrict withdrawals before age 59 1/2. You can only get money out of these types of retirement plans prematurely if you have a demonstrable hardship, such as a pending foreclosure or excessive medical bills. Some plans restrict premature withdrawals, even for hardships. Even if you qualify for an early withdrawal, you will owe a penalty of 10 percent to the IRS, on top of income taxes, unless you qualify for an exception to the penalty.
- IRS: Choosing a Retirement Plan -- Profit-Sharing Plan
- United States Department of Labor: Profit Sharing Plans for Small Businesses
- IRS 401(k) Resource Guide: Plan Participants -- Limitation on Elective Deferrals
- IRS 401(k) Resource Guide: Plan Sponsors -- 401(k) Plan Overview
- United States Department of Labor: What You Should Know About Your Retirement Plan
- IRS 401(k) Resource Guide: Plan Sponors -- General Distribution Rules
- IRS: Topic 558 -- Tax on Early Distributions from Retirement Plans, Other Than IRAs
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