Profit-sharing plans and 401k plans share several similar features but also have specific differences. Understanding these is valuable for retirement planning.
Both profit-sharing plans and 401k plans are qualified retirement plans. A qualified plan is one that must comply with the Employee Retirement Income Security Act. Companies seek qualified status for their plans in exchange for tax considerations for both the company and the employees. To be qualified, a plan must demonstrate that it covers all employees equally. The plan also must show that benefits are given to participants in an acceptable and fair way, that the compensation used as a basis for the benefits is fair and that the plan's purpose is to benefit participants.
A 401k plan allows employees to contribute part of their salary to the plan and, in most cases, direct how the funds are invested. The investment choices vary widely, from three or more mutual funds to full-blown brokerage accounts that allow employees to buy individual stocks and bonds.
In profit-sharing plans, there doesn't need to be a formula that ties the contributions to company profits. For example, 10 percent of your annual salary might be used. Another common method is for the company to allocate a fixed amount. The firm might look at the payroll and calculate each employee's share. It is also common for companies to base this allocation on age and service.
Many profit-sharing plans have added 401k features. This means you might have three "buckets" of money in one account: profit sharing, 401k contributions and possibly a company matching contribution. The trend toward such combined plans is based mostly on employee requests. If a company offered a profit-sharing plan, allowing employees to contribute their own salary doesn't add much cost, just administrative maintenance.
Regardless of the type of contribution, no employee may receive contributions that exceed $49,000, for 2009. All funds contributed to your accounts are done on a tax-deferred basis, meaning that they grow tax free until you make a withdrawal. Then contributions and earnings are taxed as ordinary income. Profit-sharing plans and 401k plans form incentives for both companies and employees to create savings for employees' retirements.