Profit-Sharing Plan vs. 401(k)

Companies usually offer 401(k), profit-sharing and other retirement plans to attract and retain talented employees. FINRA describes 401(k) plans as tax-deferred retirement plans in which employees can contribute a portion of their salaries and employers can choose to match part or all of these employee contributions. Profit-sharing plans are usually deferred retirement trusts, which employees can access upon retirement and into which employers contribute a portion of their annual profits.

Contributions to traditional 401(k) plans reduce taxable income for both employers and employees, subject to certain annual limits. Participants can choose the timing and amount of their contributions. Assets in 401(k) plans grow tax-free until retirement. 401(k) plans are portable, meaning that employees can transfer or roll over their plans into 401(k) plans offered by other companies or individual retirement accounts.

Employers can place limits on participation in 401(k) plans, such as minimum age and length of service. Employees are usually able to contribute to their plans through salary deductions. Some employers may have vesting rules for their contributions, meaning that an employee must work for a certain period before he secures ownership of the matching contributions. However, employees' contributions vest immediately.

Plans must provide periodic disclosure to participants and regulatory authorities. Some 401(k) plans are self-directed, meaning the employee decides how to invest his assets, while others are professionally managed.

There is a difference between Roth 401(k) plans and traditional 401(k) plans. The main difference between a Roth 401(k) plan and a traditional 401(k) plan is that Roth 401(k) contributions are not tax-deferred retirement plans, but withdrawals at retirement are tax-free. Unlike traditional 401(k) plans, employees cannot use Roth 401(k) contributions to reduce their taxable income.

The Roth 401(k) could benefit taxpayers who expect to have a higher taxable income at retirement, while a traditional 401(k) appeals to taxpayers expecting a lower taxable income at retirement. There a few considerations before deciding on a Roth 401(k) versus a traditional 401(k) according to brokerage firm Charles Schwab.

Profit-sharing plans benefit employees, management and shareholders because they all participate in the success of the company. Employers can choose the amount and timing of their contributions, which gives them operational flexibility. Assets in traditional profit-sharing plans accumulate tax-free until retirement. The assets usually are under professional money managers, who may decide to invest in a wide range of securities.

Participation, vesting, disclosure and asset management features of profit-sharing plans are similar to 401(k) plans. Employers should establish a formula for allocating profits to different employee groups. For example, each employee could get an allocation that is a set percentage of her salary. However, it might make sense for some firms to allocate different profit percentages.

For example, a technology company could allocate a higher percentage of its profits to its designers, while a law firm could allocate more of its profits to the partners and associates who generate most of the business. Employers may also distribute a part of their profits as quarterly or annual cash bonuses.

Although taxable, these bonuses would appeal to workers in lower tax brackets who could use the extra cash for basic expenses. Employers may combine their profit-sharing and 401(k) plans to lower administrative expenses.

Businesses should prepare written documents outlining the governance, investment policy, record-keeping process and disclosure requirements of 401(k), profit-sharing and other retirement plans. Businesses need to decide if they are going to manage these plans in-house or outsource the administration to an external investment firm. Businesses would also need to establish trust funds to manage the contributions, investments and distributions of the assets.