How A Profit-Sharing Plan Is Different From A Traditional 401(k)

Both profit-sharing plans and 401(k) plans are types of retirement plans. These plans allow employers or employees to make pre-tax contributions into an account which can then later be accessed by the employee. Funds are not taxed until withdrawn.

Retirement plans like these are crucial to ensure the financial security of employees and also serve to retain and motivate employees.

Although both plans contribute to retirement savings, there are some differences. While a 401(k) allows employee contributions, profit-sharing plans (PSPs) are only contributed to by the employer, based on the profitability of the company over a set time period, using a set formula to determine contributions.

W‍hat Is A Profit-Sharing Plan?

A profit-sharing plan can take many forms. Generally, though, it's a retirement plan where the employer shares a percentage of the company's profits with eligible employees. PSPs are discretionary plans, which means the employer can determine how much to contribute based on profits and a set formula. There are no employee contributions to a PSP.

Profit sharing plans can also be set up as cash plans where a portion of profits are paid directly to employees and taxed as if it is normal income, rather than the profit share going into a retirement plan.

Eligibility criteria for employees will differ between companies, but typically it requires employees to be over the age of 21 and have been working at the company for a year or longer.

A formula is used to determine the portion of profits shared with the employees. It can be a fixed-dollar amount, a percentage, or a more complex method. These formulas tend to take into consideration the employee's compensation, total compensation, and total profits.

There are different kinds of profit-sharing plans, including:

• Pro-rata: Employees all receive the same contribution amount (fixed dollar or percentage).
• Age-weighted: A greater percentage of contributions are allocated to aging employees since they have less time to save for retirement.
• New comparability: Employees are divided into groups, and each group gets a different percentage of profits.
• Comp-to-comp: First, total compensation is calculated, then each employee's salary is divided by the total employee compensation, which gives a percentage that determines each employee's profit portion. Highly compensated employees earn more of the company's profits.

Employer contributions are tax-deductible, and employees will only have to pay taxes once they withdraw the funds if the profit-sharing plan is set up for retirement — cash plans will be taxed as normal income.

Want to get start with profit sharing or explore how it could work for your business? ShareWillow's free Profit Sharing Plan Template has everything you need to build and launch a profit sharing plan. With this template, profit-sharing distributions are easily calculated and it'll save you hours of manual work.

What Is A 401(k)?

A 401(k) plan is a retirement plan that is funded by an employer as well as eligible employees. It has tax benefits, as employees are able to save their pre-tax income and plan for their retirement. Essentially, employees defer some of their salary into the plan, before tax.

It is named after the section of the tax code that created these retirement plans.

Employees who are eligible for this kind of plan can work in the private industry, government sector, SMBs, or even be self-employed. Historically, an employer would set up the 401(k), but in recent years, brokers have set up these plans for self-employed individuals.

Workers have the option to defer some of their pre-tax salary into their 401(k) plan, and employers have the option to match their contributions. These funds are then invested in company stock, mutual funds, or even exchange-traded funds (EFTs).

As mentioned, there is no income tax paid on contributions, and tax is only paid once the funds are withdrawn for retirement. Employers also enjoy tax advantages as their contributions to the retirement plan are tax-deductible.

The Internal Revenue Service (IRS) has set contribution limits. In 2023, the tax-deductible contributions could not exceed $22,500. If employees are older than 50, they can contribute an additional $7,500 each year.

Types Of Profit-Sharing Plans

There are two main types of profit-sharing plans, although there are also variations on these plans. Let's take a closer look at the key features of each profit-sharing plan.

Stand-alone profit-sharing plan

This kind of profit-sharing plan is completely funded by employer contributions. Employees can't make any salary contributions, making these plans much easier to manage and track.

The employer contribution is up to the employer's discretion, as well as the company's profits over a set time period (quarterly or annually). It is also determined by the formula used.

The biggest disadvantage of this type of profit-sharing plan is that employees are not allowed to contribute - meaning they lose out on tax-advantaged savings.

Profit-share 401(k) plan

These profit-sharing plans are a combination of traditional 401(k) plans and typical PSPs.

Employees are able to contribute or defer part of their salary, while employers contribute too. This kind of profit-sharing plan is a great advantage to employees. They feel like they are valued by their employers and that their financial future is secure.

Employers can make matching contributions, or determine contributions based on the business's profitability.

A profit-share 401(k) plan can be used to augment Safe Harbor 401(k) plans. A Safe Harbor 401(k) requires that employer contributions are fully vested - no matter whether it is matching contributions or limited to contributing employees.

Profit Sharing vs 401(k): Key Differences and Similarities

With both 401(k) plans and profit-sharing plans offering retirement funds for employees, we also need to consider the differences between these kinds of plans.

Contributions

Only an employer can contribute to a profit-sharing plan, and the contribution amount is determined by the profitability of the company as well as the formula used (based on the type of plan). Because employees benefit directly from the success of the company, they are motivated to work toward the company's financial goals.

401(k) plans allow employees to defer their salary into the plan, and employers can also make matching contributions.

Notably, the IRS sets contribution limits for both 401(k) plans and profit-sharing plans.

Vesting

Vesting schedules are variable for both plans, depending on the design of the retirement plan.

Commonly, profit-sharing plans' vesting schedules are graded over a couple of years.

For 401(k) plans, there are two main types of vesting schedules:

• Immediate vesting schedule: Employee contributions are 100% vested.
• Graded vesting schedule: The contributions become gradually non-forfeitable over time.

Investment options

The investment options can vary based on the employer's discretion. They are determined when the plan is set up. Typically, both 401(k) plans and PSPs are invested in mutual funds and company stock.

Other options for investment include EFTs, target-date funds, or individual bonds. The investment option selected by the employer will have an influence on the growth of the savings in the retirement fund.

Tax benefits

Both a 401(k) and a profit-sharing plan offer tax advantages to employers and employees.

The specific benefits will depend on the plan chosen. Generally, any contributions to these plans are tax-deferred, which means no tax is paid on contributions. Tax is only paid once the money is withdrawn from the retirement plan.

One of the main differences between 401(k) and profit-sharing plans is that only employers contribute to a profit-sharing plan (as discussed). These contributions are tax-deductible, which is a big benefit to employers.

Tax Implications

Both 401(k) plans and PSPs allow contributions to the plan before tax. This means that the amount of money in the retirement plan account is maximized. Typically, any earnings in these plans are exempt from tax until funds are withdrawn. However, the taxation requirements vary based on the type of plan the employer opts for.

Profit-sharing plan tax implications

As mentioned, employer contributions to the profit-sharing plan are tax deductible. Therefore, the company can reduce its taxable income based on the contributions it makes to the profit-sharing plan.

Employees don't make any contributions to a profit-sharing plan. However, when they withdraw the funds, they will have to pay taxes.

Any investment gains (like interest, capital gains, or dividends) are also exempt from annual tax.

401(k) tax implications

As with a profit-sharing plan, any employer contributions to a 401(k) are tax-deductible.

Employees are able to defer their salary into their 401(k) before tax, and will only have the funds taxed when it is withdrawn. The investment gains are also exempt from annual tax.

In certain instances, employees can make after-tax contributions through a Roth 401(k) option. With this option, any withdrawals are tax-free.

If employees wish to withdraw their funds before the retirement age of 59 and a half, they may face a 10% penalty for early withdrawal, in addition to the regular tax paid.

Choosing Between Profit Sharing Plan and 401(k)

Employers have an important choice to make when it comes to profit-sharing vs 401(k) plans.

Profit-sharing plans are discretionary, with employers deciding how much to contribute based on the financial success of the company. With a 401(k) (depending on the type of plan), employers may have to match their employees' contributions.

Because of the nature of PSPs, there is less administration to manage these plans when compared to 401(k) plans. Additionally, employees may appreciate profit-sharing plans more as they feel more appreciated by the company.

There is also the option of a hybrid model - the profit-sharing 401(k) discussed above.

As an employee, you will not really have a choice between a 401(k) and a profit-sharing plan. This is because the choice is up to the employer. However, an employee does have the choice of their salary deferrals when it comes to a 401(k), enabling them to decide how much to invest each month.

Profit-sharing plans are much more passive as employees can't contribute and also don't have a say in how much of the profit is shared with them. Different formulas can be used, and oftentimes highly compensated employees earn a greater portion of the profits.

FAQs

Are profit-sharing contributions mandatory?

No, profit-sharing contributions are at the employer's discretion, and in years where the company didn't make a profit, contributions can be zero.

Can employees have both a 401(k) and profit-sharing plan?

Yes, it is possible to have both. Some employers offer both types of employee retirement accounts to help employees save more for the future. These can be either separate plans or a single, combined plan.

In Summary

Both profit-sharing and 401(k) plans hold benefits for employees and employers. Not only are there tax advantages, but these plans provide employees with a sense of financial security for the future.

Having employers contribute to an employee's retirement plan can make that individual feel appreciated, which can motivate them to work harder and stay loyal to the company.

There are some key differences between the two types of plans, predominantly:

• The contributions,
• Contribution limits set by the Internal Revenue Service,
• Vesting schedules, and
• Eligibility criteria.

Determining which plan is best is up to the employer, as is the employer's profit-sharing contribution unless there is a mandatory matching contribution determined by the 401(k) plan.