profit sharing

What’s the Difference Between Profit Sharing and a 401k?

Retirement planning can be complicated. Every employer is different, and every employee has a different dream for how they’ll spend their golden years.

Let’s start by looking at some important retirement planning terms:

Defined Contribution Plan. This type of retirement plan is funded as the employee earns an income. Both the employee and the employer may contribute to it. Because the amount funded is variable, the benefit is undefined. A 401(k) is a defined contribution plan.

Defined Benefit Plan. The employer is responsible for funding this retirement plan. The employee may accept a lump-sum disbursement upon retirement, or monthly payments for the remainder of their natural life. A pension is one example of this type of plan.

Types of Defined Benefit Plans

Every qualified retirement plan falls into one of two categories: Defined Benefit Plan or Defined Contribution Plan. There are three types of defined benefit plans:

Flat Benefit Plan. Every employee receives the same retirement income from their employer once they reach a minimum number of years of employment.

Unit Benefit Plan. The employee receives retirement income from their employer that is proportional to their salary. Retirement compensation could be a percentage of their previous salary or calculated using a formula that multiplies a fixed dollar amount by the number of years of service to the company.

Variable Benefit Plan. The employer funds a retirement account for all employees. Employees earn a “unit” for every year of service to the company. The number of units an employee has accumulated decides what percentage of the retirement fund they are personally entitled to.

Types of Defined Contribution Plans

There are four major types of defined contribution plans:

Profit Sharing Plans (PSP). A portion of the company’s profits is deposited in this qualified retirement account every quarter. The employee is responsible for managing the investment of the funds in this type of account.

401(k) Plans. The employee is responsible for making pre-tax contributions from their paycheck. The funds grow tax-deferred. Some employers offer matching funds or a profit-sharing plan to supplement their 401(k). Other employers do not contribute at all. The employee manages the investment of funds in this account.

Employee Stock Ownership Plans. The employer regularly purchases securities in the company on the employee’s behalf. The company’s stock performance determines the value of the funds in this type of account.

Money Purchase Plans. The employer contributes a set dollar amount every year into the employee’s retirement fund. The amount is usually equal to a percentage of the employee’s salary. If the company is unprofitable, the contribution must still be made.

Different Types of Profit-Sharing Plans (PSP)

A profit-sharing plan (PSP) allows the employer to share a percentage of the company’s profits with their employees. The funds are deposited into a qualified retirement account. If the company is unprofitable, no employer contribution is required.

Many employers offer a PSP plan to supplement their employee’s 401(k) plan. This should not be confused with employer matching contributions – which require the employee to contribute to their 401(k) before the employer matches.

Profit-sharing plans provide the employee with a contribution to their retirement plan, even if they do not contribute from their paycheck – as long as the company is profitable.

There are three types of profit-sharing plans:

Pro-Rata Plans. Every employee is treated the same. They receive a retirement contribution that is proportional to their salary.

New Comparability Profit-Sharing Plans. This plan allows the company to divide their employees into different classes. One group can receive a substantially higher contribution than another.

Age-Weighted Profit Sharing Plans. Employees receive a retirement contribution based on the number of years they’ve been employed with the company. This rewards employees that have been with the company longer.

Employers love profit-sharing plans:

A PSP allows an employer to contribute to their employee’s retirement without requiring contributions during times when the company does not earn a profit. Some employers feel that this gives their employees additional motivation to help the company grow and prosper. And it protects the company from incurring additional compensation liability during lean times.

There may also be vesting requirements for employees that receive retirement contributions as part of a PSP. This means that funds may be returned to the company if the employee leaves their employer before they are fully vested. This further incentivizes employees to remain loyal to their employer.

Employees love profit-sharing plans:

Many employees enjoy having the ability to increase their compensation. When the organization is working hard and experiencing success, the employees enjoy a proportional increase in their compensation.

Older employees that have served the company for a longer period of time may enjoy a higher percentage payout than newer, younger employees.

401(k) and Profit-Sharing Plan Contribution Limits

The IRS limits how much an employee can choose to defer into their 401(k) and/or PSP. These limits are cumulative, meaning employees need to look at their entire retirement portfolio to ensure compliance.

In 2019, the limit was increased to $19,000 per year for contributions by any one employee to a traditional or safe harbor 401(k).

The contribution limit for SIMPLE 401(k) plans was also increased in 2019 to $13,000.

If you are fifty years of age or older, you are allowed to make additional “catch-up” contributions to your 401(k). The limit for traditional and safe harbor 401(k) plans is $6,000. The limit for SIMPLE 401(k) plans is $3,000.

Total Tax-Deferred Retirement Contribution Limits

Many employees have multiple retirement accounts. It’s important to understand IRS limits on deferred compensation.

The total amount an employee can defer in 2019 is $56,000 (up $1,000 from 2018) or 100% of their salary (whichever is lower).

This includes non-elective contributions made by your employer. For example, if your employer automatically contributes $40,000 in one year to your retirement account, the limit on your elective contributions may be less than $19,000 or $13,000.

It’s always a good idea to consult a tax professional when making changes to your retirement plan. We’ve done our best to give you a lay of the land, but your situation is unique and deserves specialized advice.

In most cases, it makes a great deal of sense to allow your retirement dollars to grow tax-deferred. The plans outlined above can give you the financial cushion you need to enjoy your golden years on your terms.

Different types of annuity

Understanding Different Types of Annuities (and 3 Smart Questions to Ask)

Americans are faced with many options when it comes to saving for retirement and wading through all of these choices can be a daunting task. There is no one-size-fits-all plan when it comes to how you should manage your savings, and maximizing your own retirement dollars may mean a tiered strategy with different types of accounts.

When it comes to retirement planning, many individuals will use their 401k’s and IRA’s as their primary source of income after working; however, those with extra money to invest beyond the contribution limits of a 401(k) or IRA may look for other tax advantaged investment vehicles, such as annuities.  The primary reason why? There is no contribution limit! But this does not mean annuities are free of “cons” or drawbacks—they certainly have a few. Let’s explore the different types of annuities and the basics of how they work.

What Is an Annuity?

Annuities, such as fixed-indexed annuities, income annuities, and variable annuities, are ultimately a contract between you and an insurance company. You are effectively paying that company for a fixed income stream in your retirement.

As is the case with any contract you sign, you must read all of the fine print when it comes to an annuity, and this means asking lots of questions, too. We’ll get to some of those questions shortly. First, we will explore the characteristics of the different types of annuities and how they can impact your investment.

Different Types of Annuities

You will hear a number of different descriptive terms associated with annuities, but let’s think about dividing those terms into the categories of how you INVEST and DRAW INCOME.

In terms of how you invest, annuities can be FIXED or VARIABLE. As you might guess from the names, “fixed” annuities are the more conservative option of the two, preferred by those who are risk averse or do not want their investment to be subject to market volatility. Your interest rate and annual annuity pay out is guaranteed by the insurer. In a variable annuity, you take on greater risk, and possibly a greater reward by investing in a portfolio of mutual funds. You direct the insurance company to invest your money into a number of funds on your behalf. So the performance of your portfolio will be largely determined by the asset allocation that you construct as well as the performance of the individual funds you have chosen.

In terms of how you get paid, annuities can be IMMEDIATE or DEFERRED. Typically, immediate annuity pay outs will be chosen by investors who need to generate a retirement income stream now, whereas deferred annuity payments will be chosen by those looking to accumulate wealth in a tax advantage vehicle with the intention of creating income at a later date. Just as it is the case with a 401(k) or IRA, any growth within the annuity will be taxed when withdrawn from the annuity, whether the pay out is immediate or deferred.

This is just the tip of the iceberg when it comes to understanding types of annuity and buyers should be wary of rushing into an annuity contract without asking many questions.

Below are 3 important questions to ask any financial advisor in San Diego or Los Angeles:

How is the company rated?

We read restaurant reviews before taking the chance on a $50 meal so we should certainly take the time to review insurance companies before investing a whole lot more on an annuity. Take the time to review and research the insurance company to ensure it has a solid reputation and outstanding consumer ratings. A handy guide to insurance company ratings can be found here.

What is the TOTAL cost including EVERY fee?

This is one of the most commonly cited “cons” when it comes to annuities—the numerous fees that can be associated with them. You need a clear picture of every possible fee before you decide to buy. Fees can include commissions to the agent or broker, surrender charges (which you will pay if you pull the money out before the contract ends – typically 4-10 years) mortality & expense fees, administrative fees and annuity rider fees.

What are the withdrawal penalties?

Be sure you are clear on any and all penalties associated with the early withdrawal of your funds; Most annuities have surrender schedules to prevent investors from drawing all of their money out. A 7 year declining surrender charge schedule will typically look like this:

Year                     1     2     3     4    5     6     7

Surrender %      7   6     5    4     4     4     3

Most annuities have a 10% free annual withdrawal amount that is exempt from the surrender charge.

Is An Annuity Is Right for Me?

When it comes to determining whether an annuity is suitable for you, it’s important to understand how it fits within your financial picture. As you can see from this brief article—where we only skimmed the surface in of how annuities work—this whole process can be quite complicated and overwhelming for the average investor. When it comes to protecting your nest egg and maximizing your income in retirement, it’s important to understand all aspects of your financial situation including cash flows, taxes, your existing investment portfolio and your goals.

If you don’t have a clear understanding of all these areas of your financial situation, it may make some sense to work with a fee-only financial planner. While it may create an additional expense in the short-term, there is a tremendous amount to be gained in the long term.

Working with a financial planner to make decisions about annuities, mutual funds, 401(k) s, IRAs, and any other retirement strategies will ensure you come up with a balanced approach that will make the most of your situation.

Contact Satori Wealth Management

Speak with the team at Satori Wealth Management today to discuss your financial future.  We’re ready to help you understand the Safe Withdrawal Rate and make the right decision to live the retired life of your dreams.  Click here to contact our team today to receive a free consultation.

Sources and Additional Reading