If your employer offers both a 401(k) plan and a profit-sharing plan, that's to your benefit. Having two different plans gives you some control over the amount of your retirement savings, and it allows your employer to make additional, flexible contributions to your retirement savings. Some profit-sharing plans aren't geared for retirement; they immediately pass part of their companies' profits on to employees. But many profit-sharing plans are set up to provide money for retirement.
401(k) for Employee Savings
A 401(k) plan allows employees to defer a portion of their salaries into tax-advantaged retirement accounts. These 401(k) contributions are before-tax, reducing an employee's taxable income. The account grows tax-deferred until withdrawals are made in retirement. Many employers offer matching funds, adding to the employee contributions in a specified ratio. Although the employer may include matching contributions to the plan, the employee primarily controls how much money goes into her 401(k) account.
Profit Sharing for Flexibility
The amount of contributions into a profit-sharing plan are entirely at the discretion of the employer. The company can decide each year how much money is available to pay into profit sharing, and then contributions are made into the employee retirement plan accounts based on each employee's salary or wages. A profit-sharing plan gives a lot of flexibility to the employer. The employer also sets sets features such as investment choices and vesting schedules for the plan.
Single or Separate Plans
The tax rules allow a profit-sharing plan to also include the 401(k) employee contribution features. A single plan can be both a profit-sharing plan and a 401(k) plan, allowing the employees to have both contribution types combined into a single account. A company can also decide to have the two types of retirement plans as separate plans. The business might want to offer different features in the two plans, or maybe one plan was already established and it was easier to set up an additional plan rather than add features to the company's existing retirement plan.
The tax rules put limits on how much an employee can defer into his 401(k) account and the total amount of contributions from all plans that can go to an individual employee's savings. As of the end of 2012, the annual maximum amount of salary that could be deferred into a 401(k) plan was $17,500. The limit for total retirement plan contributions including salary deferral, 401(k) matching funds and profit-sharing was $51,000. Employees older than 50 could increase these amounts by $5,500.
- IRS: IRS Announces 2013 Pension Plan Limitations; Taxpayers May Contribute Up to $17,500 to Their 401(k) Plans in 2013
- U.S. Department of Labor: Profit-Sharing Plans for Small Business
- Forbes: How 401(k) Profit Sharing Helps Small-Business Owners Maximize Their Savings
- U.S. Department of Labor: 401(k) Plans for Small Businesses
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.