Profit-sharing plans vs. 401(k)s: Which is best for retirement?

Exploring retirement options? Let's break down two popular choices: profit-sharing plans and 401(k)s. Ultimately, a 401(k) is a profit-sharing plan that permits employee contributions. Both plans offer tax benefits and are funded with pre-tax contributions, but they work a little differently.

The main difference is that you contribute part of your paycheck to a 401(k), while in a profit-sharing plan your employer makes contributions voluntarily. 

Each option has unique tax implications and can affect your retirement savings differently. Explore which best suits your financial goals below. 

What is a profit-sharing plan?

A profit-sharing plan is a tax-deferred employer-sponsored retirement plan that your employer funds, typically with the company’s profits. Employees don’t contribute to a profit-sharing plan themselves, and employers choose how to distribute contributions as long as the formula is fair and documented in writing. 

Some key features include:

• Employers can enforce eligibility rules that delay enrollment until a certain age or tenure with the company. 
• Cash and company stock are valid contributions.
• Contributions are typically provided from a company’s profits, and depending on your plan, business performance might impact contributions on your behalf.

Vesting with profit-sharing plans

It’s also important to understand vesting, which is a process of gaining ownership of stocks or other employer-provided assets. For example, the company might give you restricted stock units, but you won’t own them until you meet certain obligations, such as working at the company for a period of time.

Your employer can also place your benefits on a vesting schedule, which delays them until you meet certain milestones. For example, you might not receive profit-sharing contributions until you’ve been with the company for two years, or you might get a lump sum contribution once a year. 

One goal of a profit-sharing plan is to keep you loyal to the company. If you like your current career and plan to stick around for a while, this might be fine, or if the company has immediate vesting.

The employer can choose among a few types of profit-sharing plans.

Types of profit sharing

Employers must calculate profit-sharing contributions equally across the company, so the highest-paid employee’s contributions are proportional to the lowest-paid employee’s benefits. 

Each company gets to choose a plan formula that allocates its profits accordingly. They have options, but their final formula must pass IRS regulations.

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In a Flat Dollar Amount plan, the same dollar amount is equally distributed across eligible employees.

Example: X Corp. wants to distribute $10,000 equally among three eligible employees with different salaries.

Pro Rata plans equally distribute percentage-based profit shares across eligible employees. Total contribution is divided by the total compensation of all eligible employees, and each employee's salary is multiplied by the contribution percentage.

Example: X Corp. distributes 10% of its profits among three eligible employees with an $130,000 combined eligible compensation.

With a New Comparability model, employers assign different contributions to different groups of employees (“allocation classes”), typically so owners and highly compensated employees receive larger contributions.

Example: X Corp. assigns a 10% contribution rate for senior executives and 5% non-discriminatory contribution rate for less experienced employees.

Age-weighted contributions are where older employees may receive larger contributions than younger employees with the same salary based on their age.

Example: X Corp. contributes $20,000 to its age-weighted plan among three eligible employees. The older employee earns larger contributions to catch up on retirement.

In Social Security Integration plans, base contribution percentages are equal for all eligible employees up to the Social Security Taxable Wage Base ($168,600). Employees earn a higher rate on excess contributions above the limit.

Example: Each employee earns 4% of their salary annually, up to $168,600. Wages over the limit earn 6% contributions.

What’s a 401(k)?

A 401(k) is also an employer-provided retirement plan where you’re responsible for making regular contributions from your paycheck. 

A 401(k) is a reliable retirement account that allows you to make consistent contributions based on your financial goals and comfort. You can contribute up to $23,000 in 2024, but you certainly don’t have to max your 401(k) if you don’t want to or can’t. 

All funds you contribute are immediately vested, meaning they’ll move with you if you change jobs. Now, employer contributions to a 401(k), including matches, might not be automatically vested, but any direct contribution you make is fully vested. 

Some employers offer both traditional and Roth 401(k)s, and you may be able to contribute to both.  

Traditional 401(k)s are funded with pre-tax contributions, so you reduce your annual taxable income and tax bill today. Taxes on your contributions and earnings are delayed until withdrawal.

Roth accounts are funded with after-tax income, and the account grows tax-free. So once you retire and start taking money out, you don’t owe any additional taxes. You can also withdraw from your contributions at any time without penalty, but you can’t access your earnings until age 59½. 

Key features of 401(k)s:

• Some employers offer a matching benefit, so they will contribute money to your account for every dollar you contribute up to a certain amount. Usually the limit is a percentage of annual salary. 
• Automated contributions come directly from your paycheck.
• Since you contribute to the account directly, you get all of the tax advantages, including tax-deferrals and reduced taxable income (for traditional accounts). 
• You have flexibility to choose investments from an assortment of stocks, bonds, and mutual funds. 
• Catch-up contributions kick in once you reach age 50 and increase your annual contribution limit to help you prepare for retirement. 

Tax implications

Both traditional 401(k)s and profit-sharing plans are tax-deferred, meaning you don’t make income tax payments until distribution – likely in retirement. However, a 401(k) can offer immediate tax advantages to an employee that a profit-sharing plan can’t. 

A traditional 401(k):

• Reduces your current taxable income.
• Is tax-deferred, so you don’t owe income taxes until you cash out.

A Roth 401(k):

• Funded with after-tax income. 
• Earnings grow tax-free.

Profit-sharing plans reduce taxable income for the company making the contributions, but that doesn’t help your tax bill. And you’ll still owe income taxes when you take distributions in retirement. 

Income and contribution limits

There are no income limits to enroll in either a 401(k) or profit-sharing plan. However, there are maximum annual contributions for each. 

401(k) personal contribution limits max out at $23,000 in 2024, but it changes each year. Employees over age 50 can also add an extra $7,500 in catch-up contributions for a total of $76,500. 

‍Profit-sharing plans contribution limits are set at 100% of your compensation, up-to $69,000 in 2024.

Pros and cons

Ultimately, you can’t decide what retirement options your employer provides, but you can choose who you work for. So, if you’re on the hunt and comparing retirement benefits, here’s an overview of profit-sharing plans vs. 401(k) plans to help you. 

401(k)

A 401(k) is great at any stage of your career when you want the ability to save consistently and have years ahead of you to generate tax-deferred compound growth. You can adjust contributions as necessary and take advantage of benefits like employer matches.

Pros:

• Reduces your taxable income.
• Defers income taxes until distribution.
• Offers tax-free Roth options.
• More control over your contributions.
• Potential for employer match.
• Some control over your investment options.
• You’re fully vested and entitled to your contributions immediately.

Cons:

• Make contributions out of your paycheck, reducing your taxable income. 
• Employer matches are subject to vesting schedules

Profit-sharing plan

Profit-sharing plans make more sense as you approach retirement age – especially if you’re in a high-earning position with a growing company. You have the potential to earn higher contributions that provide a nice boost in your last few working years, but you will not be able to contribute on your own — and there’s no guarantee your employer will either 

Pros:

• Defers income taxes until distribution.
• No personal contributions. 
• Larger individual account contribution limit at 100% of your annual compensation, up to $69,000.

Cons:

• No personal tax deduction.
• No control over contribution size or frequency. 
• Vested schedule might delay or cause you to forfeit your benefits.
• Payout is based on profitability, which isn’t guaranteed. 
• Eligibility requirements for age or tenure may delay enrollment.

The Playbook take: Control your retirement strategy

Ideally, you can contribute to a 401(k) as well as a profit-sharing plan, but if you have to choose, we think a 401(k) is the way to go. It’s the best bet for your tax bill, and you get control over your contributions and take them with you when you leave the company without worrying as much about vesting requirements.

But if you want more spending money in your pocket, profit-sharing plans won’t eat into your paycheck while your retirement continues to grow. And with immediate vesting, the contributions are yours, so you don’t have to worry about sticking around for several years. 

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