Choosing a Retirement Solution for Your Company: Profit Sharing vs 401(k)

Ashleigh Zeller, CPA

As your company grows, offering a retirement plan is an important benefit to help recruit and retain employees. There are a number of options available; in this post, we’re going to review two of the most common plan types – profit sharing plans and 401(k) plans.

These plans are alike in several ways. Both are qualified, tax-deferred retirement plans that allow participants to contribute pre-tax earnings; the principal and subsequent earnings are not taxed to the employee until withdrawn. In both plans, the maximum amount that can be contributed to a participant’s account is the lesser of $52,000 or 100% of the participant’s salary, though, for corporate tax purposes, a company may not deduct more than 25% of total compensation expensed for the year. Both plans allow for withdrawals (i.e., hardship, in-service, etc.) as well as loans.

When it comes to retirement savings strategies, both profit-sharing plans and 401(k) plans are attractive benefits for employees who can share in the company’s growth and utilize the plan as part of their personal retirement planning strategy.

Profit Sharing vs 401k

While these two plan types are very similar, there are a few areas in which these plans differ:

Types of Contributions – Profit-sharing plans allow for only employer contributions, which is determined annually at the discretion of the company. On the other hand, 401(k) plans allow for employee contributions (up to $17,500 per year, or $22,500 per year for employees 55 or older) and may contain elective or non-elective employer contribution provisions.

Profit-sharing plans do not allow for any contributions to be made after earnings are taxed (“after-tax contributions”), while a 401(k) plan does allow employees to make after-tax contributions.

Flexibility of Employer Contributions – Profit-sharing plans allow employers to allocate contributions by a variety of different models: salary ratio, integration (or permitted disparity), age-weighted, new comparability, and more, as long as they satisfy non-discrimination requirements. See this report (PDF) prepared by Manning & Napier for details on these methods.

Employer contribution methods permitted for 401(k) plans are much more restrictive, limited primarily to methods based on the employee’s deferral.

Eligibility Requirements – For a 401(k) plan, a one-year service requirement is the maximum service period that can be used to determine the eligibility of employees to participate in the Plan. However, a profit-sharing plan may use a two-year service requirement instead, though to do so requires immediate vesting of contributions.

Other eligibility requirements such as age and employee type (i.e., union, leased, etc.) remain the same between the two types of plans.

It’s important to note that creating either one of these plans for your business comes with a number of specific compliance requirements and fiduciary responsibilities. With either plan, you will need to file a Form 5500 with the Department of Labor. Once your plan reaches 100 participants, Employee Retirement Income Security Act (ERISA) requirements mandate that your plan be audited.

If your company can afford the administrative cost, offering both plans provides the greatest incentive for employees and the best tax-saving opportunities for you. For a detailed comparison of these and other retirement plan options, see this comparison table (PDF)prepared by You can read more about fiduciary responsibilities at the DOL’s website.

Share this post