When to Use a Profit Sharing Plan Instead of a 401(K) Plan

There's been a revolution in the retirement-plan world, and many employers have chosen to replace traditional pension plans with defined-contribution 401(k) plans, although some employers still provide access to broader-based profit-sharing plans. Knowing the difference between these two types of retirement plans is essential when choosing the right plan for your company.

The Biggest Difference Between 401(K) Plans and Profit-Sharing Plans

The most important distinction between 401(k) plans and profit-sharing plans is who contributes to the employee's plan account.

  • In a 401(k) plan, the principal responsible for making contributions are the employee’s. (Employers may offer matching contributions for participating workers, but it’s not a requirement, and the employer may suspend the match in future years whenever they wish.)
  • Profit-sharing plans are composed solely of employer contributions. Usually, the profit-sharing contribution is expressed as a percentage of salary thereby higher-paid workers get larger employer contributions than lower-paid workers. In a typical profit-sharing plan, every worker is entitled to receive whatever portion of the business profits the employer decides is appropriate.

Other Key Differences

There are other ways in which 401(k) and profit-sharing plans differ:

  • Employees are always completely vested in their own contributions to their 401(k) plan. Upon separation from the employer, any employee contributions to a 401(k) can be rolled over into an IRA;
  • Employer contributions -- either through employer matches in a 401(k) or from profit-sharing plan contributions – can have vesting requirements attached. These provisions require the employee to forfeit employer-made contributions to retirement accounts if the minimum work requirement is not satisfied (usually graded vesting schedule at 20% per year starting with 2 years of service);
  • Federal law gives profit-sharing plans more greater ability for on participants taking early withdrawals from their accounts:
    • With a 401(k), participants can only take withdrawals of their employee contributions upon termination of employment, permanent disability, financial hardship, attainment of age 59 ½, or death (payment to beneficiary).
    • A profit-sharing plan allows far more latitude in determining when an employee can get money out of the account before retirement (e.g. attainment of a specific age, completion of a certain number of years of service, or funds that have accomplished in the plan for at least 2 years).

Reasons Why Employers May Want to Start a Tiered or Cross Tested Profit Sharing Plan

  • Employer contributions are flexible and can change from year to year.
  • Employer contributions are based on age and compensation.
  • Employer contributions are determined using actuarial guidelines on an annual basis.
  • Typically favors older, long-term employees.
  • Every Participant can be put into a separate class and assigned differing contribution allocation.
  • Plan assets can be pooled or the plan sponsor can utilize a recordkeeping platform.
  • Participant distributions are taken in a lump sum.

While the trend has been for employers to offer 401(k) plans which leave workers more responsible for their own retirement, the ideal situation for employees is for the company to offer both a 401(k) plan and a profit-sharing plan, giving employees choices -- the best of both worlds.

Contact one of our QBI, LLC account representatives for details and assistance is establishing the best course of action for your company.