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.
Danny G. Michael is the founder and CEO of Satori Wealth Mangement, Inc. He has 20 years of experience in retirement planning working with individuals, families, and business owners.