Companies usually offer 401k, profit-sharing and other retirement plans to attract and retain talented employees. 401k plans are tax-deferred 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 401k 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 401k plans grow tax-free until retirement. 401k plans are portable, meaning that employees can transfer or roll over their plans into 401k plans offered by other companies or individual retirement accounts.
Employers can place limits on participation in 401k 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 401k plans are self-directed, meaning the employee decides how to invest his assets, while others are professionally managed.
Profit-Sharing Plan Basics
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.
Profit-Sharing Plan Administration
Participation, vesting, disclosure and asset management features of profit-sharing plans are similar to 401k 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 401k plans to lower administrative expenses.
Roth 401k vs. Traditional 401k
The main difference between a Roth 401k plan and a traditional 401k plan is that Roth 401k contributions are not tax deductible, but withdrawals at retirement are tax-free. Unlike traditional 401k plans, employees cannot use Roth 401k contributions to reduce their taxable income. The Roth 401k could benefit taxpayers who expect to have a higher taxable income at retirement, while a traditional 401k appeals to taxpayers expecting a lower taxable income at retirement.
Businesses should prepare written documents outlining the governance, investment policy, record-keeping process and disclosure requirements of 401k, 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.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.