Difference in a Profit-Sharing Plan and an IRA

Profit-sharing plans and individual retirement accounts are ways you can save for retirement and get tax benefits along the way. One of the main differences between these two types of accounts is that an employer must sponsor a profit-sharing plan, while anyone can establish his own IRA. Beyond that, contribution limits and distribution rules can vary greatly.

Contributions

Only employers may contribute to a profit-sharing plan, while only an individual can contribute to an IRA. The Internal Revenue Service establishes the limits for contributions to both types of accounts, and the limits tend to rise over time due to inflation adjustments. As of 2010, you could contribute no more than $5,000 to an IRA, but an employer could contribute the lesser of 100 percent of your compensation or $49,000. If an employer makes a contribution to a profit-sharing plan on his own behalf, he must make a similar percentage of compensation contribution for each eligible employee.

Distributions

Generally speaking, profit-sharing plans have more restrictions on distributions than do IRAs. For example, most profit-sharing plans will only allow you to take a distribution when you reach retirement age, if you separate from service with the employer or if you have worked for a certain number of years. An IRA, on the other hand, is a personal account from which you can withdraw whenever you like. Both types of accounts impose a 10 percent penalty if you take money out before age 59 1/2. Additionally, you must pay tax on profit-sharing plan and IRA distributions.

Tax Benefits

One characteristic that IRAs and profit-sharing plans have in common is tax-deferred growth. Earnings and contributions in both types of plans grow tax-deferred until withdrawal. When you contribute to an IRA, you are generally eligible for a tax deduction, if you are not covered by an employer-sponsored plan at work. For profit-sharing plans, your employer will also get a tax deduction for any contributions he makes, whether to his own account or to employee accounts.

Other Types of IRAs

Beyond the traditional IRA, other types of IRAs are more similar in structure to a profit-sharing plan. For example, both SIMPLE and SEP IRAs are retirement plans for small businesses, much like a profit-sharing plan. Both types of IRAs provide for employer contributions as well. However, both SIMPLE and SEP IRAs allow you as an employee to take out money whenever you would like, and with a SIMPLE IRA you can even make your own contributions as well.

References

• IRS Publication 590: Traditional IRAs
• U.S. Department of Labor: Profit-Sharing Plans for Small Businesses
• IRS; Choosing A Retirement Plan -- Profit-Sharing Plan; January 2011
• U.S. Department of Labor: SIMPLE IRA Plans for Small Businesses
• U.S. Department of Labor: SEP Retirement Plans for Small Businesses