Pension and profit-sharing plans are retirement plans that employers set up on behalf of their employees and for their benefit. These plans may be one in the same, but they may also describe two very different kinds of retirement plan. An employer must understand the difference between the two before either one is established.
A pension plan broadly describes a retirement plan funded in part, or in whole, by the employer. Contributions are normally required by the employer every year, except in cases where part, or all, of the pension consists of a profit-sharing plan. The employee receives the benefit payment from the pension when he retires. Normally, pension payments are made via an annuity. The annuity guarantees the income to the employee when the employee retires for as long as the employee lives.
A profit-sharing plan is a type of retirement plan in which the employer shares profits with the employee. The company's profits are split up among all employees and the employee may invest the proceeds as he sees fit. Benefits are not necessarily paid out using an annuity at retirement, though an annuity may certainly be used. Instead, the employee takes the money and rolls it over into another retirement plan, like an IRA. From here, he may withdraw the money or convert the savings to guaranteed income payments. The employer is not obligated to contribute a certain amount of money and may forgo a contribution altogether, even if there are profits to be distributed.
With both retirement plan arrangements, the employee benefits from employer contributions. The employer is effectively funding the employee's retirement plan. In both instances, the employee has the opportunity to receive a guaranteed income from the retirement plan, which will ensure that both he and his spouse do not run out of income. On top of this, a pension plan offers survivor benefits so that if the employee dies, the spouse receives a benefit from the pension.
All pension plan payments are treated as ordinary income subject to income tax. This money must be included with all other sources of income the employee receives during the year. Taxes are paid in the year that the income is received.
- Internal Revenue Service; Publication 575: Pension and Annuity Income; February 2011
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, et al.; 2007
- Internal Revenue Service. "Choosing a Retirement Plan: Profit-Sharing Plan." Accessed Feb. 25, 2020.
- Internal Revenue Service. "Choosing a Retirement Plan: Money Purchase Plan." Accessed Feb. 25, 2020.
- Internal Revenue Service. “Publication 560: Retirement Plans for Small Business,” Page 5. Accessed Feb. 25, 2020.
- Government Printing Office. “Treas. Reg. Section § 1.401–1 (b) General Rules. (1)(i),” Page 11. Accessed Feb. 25, 2020.
- Internal Revenue Service. "Annuities - A Brief Description." Accessed Feb 28, 2020.
- U.S. Department of Labor, Employee Benefits Security Administration (EBSA). “What You Should Know About Your Retirement Plan,” Pages 18, 21. Accessed Feb. 28, 2020.
- Internal Revenue Service. "Retirement Topics - Exceptions to Tax on Early Distributions." Accessed Feb. 25, 2020.
- United States Congress. "H.R.1994 - Setting Every Community Up for Retirement Enhancement Act of 2019." Accessed Feb. 25, 2020.
- Internal Revenue Service. "Retirement Plan and IRA Required Minimum Distributions FAQs." Accessed Feb. 25, 2020.
I am a Registered Financial Consultant with 6 years experience in the financial services industry. I am trained in the financial planning process, with an emphasis in life insurance and annuity contracts. I have written for Demand Studios since 2009.