If you’ve decided it’s time to start saving for your retirement, check to see if your employer sponsors a plan. Two of the most common types of employer-sponsored retirement plans are 401(k) plans and profit-sharing plans. Both types of plans offer tax advantages and can be good ways to build up your retirement savings. However, they are structured quite differently. As an employee, you’ll generally have more control over your 401(k) plan account than your profit-sharing plan account. But both plans rely at least in part on contributions from employers.
How a Profit-Sharing Plan Works
In the past, companies often designed pension plans for the benefit of employees. Under a pension plan, businesses would contribute and invest money in such a way that employees would receive a specific monthly benefit when they retired, such as $2,000 per month. As such, these traditional pension plans are known as defined benefit plans. A profit-sharing plan, on the other hand, is known as a defined contribution plan, rather than a defined benefit plan because it promises no specific outcome. Rather, the plan documents define a specific level of contribution from employers. Whatever is in the account when an employee takes a distribution is what they receive, rather than a pre-defined and guaranteed amount.
Many employers prefer profit-sharing plans over pension plans or other defined benefit plans because they allow the employer flexibility. Under the terms of a profit-sharing plan, employers are not required to make any contributions at all to employee accounts. However, Department of Labor regulations specify that profit-sharing distributions must be “substantial and regular.” Although this is a loosely defined obligation, it means that a profit-sharing plan must not continue for too long without making any distributions.
The “defined contribution” portion of the plan refers to the specific rules that employers must follow if they choose to make contributions. For example, a profit-sharing plan might specify that if a contribution is made, it must be made as a percentage of an employee’s salary and that contributions cannot favor certain employees over others.
How a 401(k) Plan Works
A 401(k) plan is another type of defined contribution plan. This means that the amount in an employee’s 401(k) account is the amount they will receive at retirement, not some predetermined benefit amount. With a 401(k) plan, employees make contributions to their own accounts, typically via payroll deduction contributions. This means that deposits to a 401(k) plan are taken out of an employee’s paycheck before they are taxed, resulting in a reduction of taxes paid.
The money contributed to a 401(k) plan is invested in some different options, typically a variety of mutual funds. Employees can generally direct their investments in their 401(k) accounts, choosing how much of each contribution will go into each fund.
Employers can contribute to a 401(k) plan on behalf of employees. Just like with a profit-sharing plan, employer contributions are not mandatory in a 401(k) plan. However, many employers make a “matching” contribution to employee 401(k) accounts; for example, a company might offer to match 50 percent of the amount that an employee contributes, up to a maximum of 5 percent of his or her salary. If an employee contributes $500, for example, an employer may contribute an additional $250. This money goes into the employee's account and is invested according to the employee’s wishes.
2018 Contribution Limits
The IRS restricts the total amount that can be contributed to both 401(k) plans and profit-sharing plans. For 2018, the total contribution limit is the same at $55,000. However, there are various restrictions that the IRS imposes on this limit. For example, employers can’t make a profit-sharing contribution to a plan that exceeds 25 percent of the total compensation paid to eligible and participating employees. From the perspective of an employee, the primary concern is the limit on employee deferrals to a 401(k) plan, as employees cannot contribute to a profit-sharing plan. For 2018, employees are allowed to contribute the lesser of $18,500 or 100 percent of the compensation to a 401(k) plan. This limit is raised by $5,000 per year for employees aged 50 or older.
What Is a Vesting Schedule?
Typically, employees don’t have the right to access employer retirement plan contributions until a certain amount of time has passed. The waiting period until an employee has access to employer contributions is known as a vesting schedule. Employers use vesting schedules to avoid having to make benefits available to part-time or short-term employees, as the administrative costs on these types of accounts can be expensive on a relative basis. Employees are always vested in their retirement plan contributions. However, employer contributions can be delayed according to one of two types of vesting schedules specified by the Department of Labor: graduated vesting and cliff vesting.
Graduated vesting means that employees gain ownership over employer contributions a little bit every year. The Department of Labor requires graduated vesting of at least 20 percent after two years, 40 percent after three years, eventually reaching 100 percent after year six.
As the name suggests, with cliff vesting, employees are entitled to nothing until the year in which they become 100-percent vested. Department of Labor regulations requires employees under a cliff vesting schedule to be 100-percent vested after three years or less.
Are Distributions Taxable?
Contributions to both 401(k) plans and profit-sharing plans are tax-deductible, and money within the plans grows on a tax-deferred basis. This means that distributions from both types of plans are taxable to the recipient.
Restrictions on Withdrawals
Both profit-sharing and 401(k) plans are long-term retirement plans. The IRS restricts withdrawals from either type of plan to one of three options. Both 401(k) plans and profit-sharing plans allow withdrawals if you terminate employment, whether that means through death, disability, retirement or any other circumstance in which you leave your job. The second option is if you suffer a hardship, such as a medical emergency or a pending foreclosure or excessive medical bills. The final option is if you reach age 59.5, in the case of a 401(k) plan, or the qualifying retirement age in your profit-sharing plan (which is commonly 59.5 but can be any age). Regardless of what your plan documents say, the IRS will levy a penalty of 10 percent of your withdrawal if you take money out of either type of plan before age 59.5, unless you qualify for an exception to the penalty.
Difference Between Profit-Sharing and 401(k)
In the profit-sharing vs. 401(k) plan debate, there is no clear “winner.” Both offer tax-advantaged retirement savings for employees. The main difference is structural; profit-sharing plans do not allow employee contributions, whereas 401(k) plans do. According to IRS regulations, a profit-sharing plan that allows employee contributions is a 401(k) plan, outlining just how similar these two retirement savings vehicles are. The other main distinction lies in who controls the investments within the account. With a 401(k) plan, employees get to choose where to put their money; in a profit-sharing plan, employers are responsible for investing the funds.
- IRS: Retirement Topics -- 401(k) and Profit-Sharing Plan Contribution Limits
- IRS: Retirement Topics -- Vesting
- IRS: Employee Benefit Plans
- IRS: 401(k) Resource Guide -- Plan Participants -- General Rules
- IRS: Retirement Topics -- Exceptions to Tax on Early Distributions
- IRS: When Can a Retirement Plan Distribute Benefits?
- IRS: Profit-Sharing Plans for Small Businesses
- IRS: Choosing a Retirement Plan -- Profit-Sharing Plan
John Csiszar served as a financial adviser for over 18 years, both for a global wirehouse and at his own investment advisory firm, earning a Certified Financial Planner designation along the way. He now works as a writing and editing contractor for private clients, with thousands of online articles to his credit, along with five educational books written for young adults.