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