Profit-Sharing Plan vs. 401k: Comparing Retirement Plan Options

Employer-sponsored retirement plans usually take the form of either a 401(k) or a profit-sharing plan. Both options are tax-advantaged, but they differ considerably in how they work. To start, employees contribute to a 401(k) and may have an employer match. In the case of profit-sharing plans, only employers can contribute, and contribution amounts differ. It’s important to understand the difference between the two. Read on to understand a profit-sharing plan versus 401k plans. 

Profit-Sharing Retirement Plan Overview

A profit-sharing retirement plan is a tax-advantaged retirement account an employer creates for employees. Usually, you will need to be at least 21 years old and have worked at the company for more than one year to be eligible.

A standard profit-sharing plan holds a mix of mainstream securities assets. Under a profit-sharing plan, the employer contributes money to employees’ accounts based on predefined criteria. The employer will have a standard formula used universally across the organization and usually tied to the company’s annual profits. 

For example, an employer might contribute 10% of all company monthly profits divided among all employee retirement accounts. Or it might establish a flat contribution, like 5% of an employee’s annual salary. Rules can be based on company profit or performance, but that’s not always the case.

Sometimes, employers will also make contributions to company stock, in which case the value of the contribution is equal to the stock’s current value. The assumption is that the employees will be more invested in the company’s long-term success. 

What A Profit-Sharing Plan Is and How it Works

A profit-sharing plan is a tax-advantaged account. While employees cannot make contributions, companies can deduct contributions from their overall corporate tax up to a limit. For 2023, that limit is $66,000 or 25% of employee compensation, whichever is less. In addition, for employees older than 50, employers may make catch-up contributions of up to $7,500 annually.  

Companies that choose profit-sharing must make contributions for all employees. The only exceptions are for employees who are very new to the company.

Like other retirement plans, you can choose how the profit-sharing retirement funds are invested. Investment options vary but are usually a range of mutual funds and employer stock.

Pros and Cons of Profit-Sharing Plans

Profit-sharing plans have advantages and disadvantages. Here are some of the pros and cons.

Pros

• Employees don’t have to contribute, adding to total benefits.
• Tax advantages lead to retirement growth.
• Many employers use both profit-sharing plans and 401(k)s, giving you the best of both worlds.

Cons

• Employer contributions aren’t mandatory, and amounts may vary.
• Earnings can be more variable.
• Limited investment options.

401(k) Retirement Plan Overview

A 401(k) retirement plan is the most common type of employer-sponsored retirement program, named after the IRS tax code that created it. These tax-advantaged accounts are traditionally only available for employees. However, recently, some brokers have offered group 401(k) options, which allow an individual to open an account.

What 401k Plan Is and How it Works

A 401(k) retirement plan allows employees to contribute to retirement. The funds grow tax-free and are only taxed when the employee withdraws them. Most employers offer a contribution-matching plan in which the employer matches up to a certain percentage or set amount of employees’ contributions.

The employer sets up the 401(k) on the employee’s behalf, but both can contribute funds. You can deduct 401(k) contributions from your income up to IRS limits. For 2023, that’s up to $22,500. If you’re over 50, you can contribute an additional $7,500. Employers can also deduct 401(k) contributions from their corporate tax, up to 25% of total compensation for all eligible employees. 

Pros and Cons of 401k Plans

There are significant advantages and a few disadvantages to 401k plans. Here's what you'll want to consider. 

Pros

• Employers match some contributions, adding to total benefits.
• Tax advantages lead to retirement growth.
• Many employers use both profit-sharing plans and 401(k), giving you the best of both worlds.

Cons

• Employer matches may be small.
• Limited investment options.
• It’s difficult to access funds early.

Profit-Sharing Plan vs. 401(k) Plan: What Are the Key Differences?

Profit-sharing plans and 401(k) plans have several key differences. Here’s what you need to know.

Eligibility

While employees can benefit from both a profit-sharing plan and a 401(k) plan, only employers can make contributions to profit-sharing plans. Employees and employers can make contributions to 401(k) plans. 

Purpose

The purposes of the two plans are similar: They’re tax-advantaged accounts that allow employees’ retirement savings to grow tax-deferred. A 401(k) plan relies heavily on employee contributions, while a profit-sharing plan relies on employer contributions, and amounts may vary. 

Types of Plans

The investment opportunities vary from plan to plan within 401(k) and profit-sharing plans. Depending on the retirement savings administrator, you might have access to different investment options. 

Tax Benefits

Both plans offer tax benefits for both employers and employees. But the advantages may vary by plan type. In general, both profit-sharing retirement plans and 401(k) retirement plans are tax-deferred, meaning you can deduct any contributions from your annual income and only pay taxes on the money you withdraw, ideally at retirement age. 

Contribution Limits

Both profit-sharing and 401(k) plans have contribution limits set by the IRS. For profit sharing, employers can contribute $66,000 or 25% of your total annual compensation, whichever is less. For a 401(k) plan, the maximum contribution is $22,500 combined between you and your employer. For both plans, anyone over 50 can make — or have their employer make — catch-up contributions of up to $7,500 a year. 

Choosing 401k vs. Profit Sharing Plan

The good news is that you may not have to choose one or the other in the debate of profit-sharing versus 401(k) retirement plans. If your employer offers both, you could take advantage of two retirement accounts. If you only have one available, learn to invest for retirement and work to maximize employer contribution, and find some of the best 401(k) investment opportunities. You can also learn how to open an individual retirement account (IRA) and find some of the best investments for retirees. 

Frequently Asked Questions