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. But a few workers are still fortunate enough to have access to broader-based profit-sharing plans, and so it's important to know what types of plans you can participate in at your employer and the differences between them.
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 worker's plan account. In a 401(k) plan, the employee is primarily responsible for making contributions to the retirement account. Some employers offer matching contributions for workers who choose to participate, but there's no requirement that the employer do so. Moreover, even if a 401(k) plan offers an employer match in a given year, the employer can suspend the match in future years whenever it wishes.
Profit-sharing plans, by contrast, are retirement accounts that are composed solely of employer contributions. In a typical profit-sharing plan, every worker is entitled to receive whatever portion of the profits of the business that the employer decides is appropriate. Usually, the profit-sharing contribution will be expressed as a percentage of salary, meaning that higher-paid workers get larger employer contributions to their profit-sharing plans than lower-paid workers do.
Other key differences
There are other ways in which 401(k)s and profit-sharing plans differ. Employees are always completely vested in the contributions they make to a 401(k) plan, but employer contributions -- either through employer matching in a 401(k) or from profit-sharing plan contributions -- can have vesting requirements attached to them. These provisions require you to forfeit employer-made contributions to retirement accounts if you don't satisfy a minimum work requirement at the employer.
In addition, federal law gives profit-sharing plans greater latitude in deciding whether participants are allowed to take early withdrawals from their accounts. With a 401(k), participants can only take withdrawals for what are known as hardship expenses. A profit-sharing plan gives the plan administrator much more latitude in determining under what circumstances a worker can get money out of the profit-sharing account before retirement.
The ideal situation for workers is one in which the employer offers a combination of both a 401(k) plan and a profit-sharing plan, giving them the best of both worlds. Yet the trend has definitely been toward leaving workers more responsible for their own retirement, and that makes 401(k) plans the more popular choice among employers lately.
One final note: If you have a 401(k) from an old employer, you can roll over that 401(k) into an IRA. If that's your situation -- or if you simply find yourself investing on your own for your retirement -- visit the Fool's IRA Center to learn more about the basics of these accounts. We'll help you get started as you discover which IRA option is best for you.
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