Profit Sharing Plan vs. 401(k)

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When recruiting prospective employees or retaining current ones, retirement savings account contributions can be a powerful tool for employers. Profit sharing plans bolster 401(k) plans with additional savings, whether the employee contributes to the 401(k) or not. They also give the company and employees tax advantages and a sense that they are building a solid financial future.

Profit Sharing Plans

Any employer can operate profit sharing plans as part of an employee's 401(k) account. Companies set up a plan to contribute a percentage of their annual profits into their employees' tax-deferred retirement accounts. A standard profit sharing plan, typically used by larger, established companies, allots the same percentage to every employee's 401(k) account. This amount is in addition to any matching funds the company contributes to the employee's elective deferrals.

The company receives tax deductions for its profit sharing contributions. The employees receive tax advantages as the 401(k) account grows on a tax-deferred basis, and employee deferrals are tax deductible. Smaller companies with fewer than 50 employees often offer an advanced profit sharing plan that allots different profit percentages to different groups within the company. This plan style gives employers even more control over when, how much and with whom they share the profits.

Traditional 401(k) Plans

Traditional 401(k) plans are tax-deferred retirement accounts in which employers have the option to match eligible employee contributions up to a certain percentage. While any employer can offer a profit sharing plan, 401(k) plans may not be offered by government entities. Employees enroll in the 401(k) voluntarily.

Although people can withdraw money from the 401(k) before retirement in some hardship cases, this is not without consequences. Employees who take a hardship distribution cannot contribute to the plan for at least six months. The Internal Revenue Service considers hardship distributions as gross income, so those who make withdrawals will be responsible for any additional taxes and penalties. The employee typically does not get access to employer contributions to the account until she is vested. This could happen incrementally over a period of years or after a certain amount of time has passed.

Other 401(k) Types

A safe harbor 401(k) is similar to a traditional 401(k), but all employer-matching contributions are vested at the time they are contributed. This means that employers can contribute to all eligible employees or those who are making tax-deferred contributions, according to IRS regulations. The SIMPLE 401(k) plan is for employers with 100 or fewer employees who received at least $5,000 for the preceding calendar year, according to IRS regulations.

Contribution Limits

The IRS limits the amount of contributions to a 401(k) and those with the profit sharing component. It limits an employee's contribution, or elective deferral, to $17,500 in 2013, while the deferral limit to a SIMPLE 401(k) plan is $12,000. If allowed by the plan, participants who are age 50 or older can also make catch-up contributions of $5,500 for 2013 to traditional and safe harbor 401(k) plans. An employer's matching contributions and profit sharing contributions cannot be more than the participant's compensation or $51,000, whichever is less. Profit sharing contributions themselves may not exceed more than 25 percent of the employee's pay.