Two of the most widely used employer-sponsored retirement plans are 401(k)s and profit-sharing plans. Both of these are tax-advantaged retirement plans, meaning that the IRS taxes contributions to these plans differently, if at all. Here’s how each of these plans work. Consider working with a financial advisor as you consider how to take advantage of these kinds of plans and boost your retirement prospects.
What Is a 401(k)?
A 401(k) plan, named after the section of the tax code which created it, is a tax-advantaged retirement account. Historically it has been available only to people with an employer, meaning that self-employed or freelance workers usually cannot use this for retirement planning. However, in recent years some brokers have begun offering group 401(k) products, which allow individuals to open an account.
In terms of structure, a 401(k) is generally an investment portfolio holding a mix of securities. The IRS puts some limits on the assets in which you can invest using a 401(k) plan. In turn, most 401(k)s only allow you to invest in various types of funds, which are buckets of investments. These are commonly target-date funds, which are funds that change as you get closer to retirement.
Your employer sets up your 401(k) on your behalf. As a result, most employers offer a pre-selected series of 401(k) accounts for employees to invest in. It is relatively uncommon for individuals to get to direct the investments made by their 401(k) account.
Money that you invest in your 401(k) is tax-advantaged, meaning that you can fully deduct every dollar that you contribute from your annual income taxes. You do not pay taxes on the money you put into a 401(k), but you do pay taxes on the money that you withdraw from this account later in life. Employers may also contribute to their employees’ 401(k) accounts. The employer also receives a full tax deduction for every dollar contributed to an eligible 401(k) account.
The IRS limits the amount of tax-deductible money you can invest in a 401(k) plan each year. In 2021, you cannot contribute more than $19,500 to a 401(k). For 2022, this number is jumping to $20,500. Beyond that, you can contribute an extra $6,500 a year if you’re 50 or older.
What Is a Profit-Sharing Plan?
Like 401(k) plans, profit-sharing plans are tax-advantaged retirement accounts that an employer runs for their employees. They share the same structure in that a standard profit sharing is generally an investment portfolio holding a mix of mainstream securities assets. The difference is in how contributions are made.
Under a profit-sharing plan, the employer contributes an amount of money to each employee’s retirement plan account based on pre-defined criteria. The employer must use a standard formula for determining how much it will contribute to each employee’s retirement account, applied uniformly across the organization, and cannot make this decision on an ad hoc basis.
For example, an employer might say that each month it will contribute 10% of all corporate profits to employee retirement accounts. Or the employer might establish a flat contribution of 5% of each employee’s annual salary to their retirement account. It is common for employers to establish contribution rules based on profits and performance, hence the name “profit-sharing plan,” but this is not necessary.
Employers can also make this contribution in company stock. In this case, the value of any contribution comes from the value of the company’s stock at the time of the contribution.
Individuals cannot contribute to a profit-sharing plan. However, like a 401(k), this is a tax-advantaged account. The employer can deduct from its corporate taxes all contributions it makes to a profit-sharing plan up to a limit. In 2021, that limit is the lesser of either $58,000 per employee or 25% of compensation. For 2022, this is increasing to $61,000 or 25% of compensation. If you’re 50 or older, you can make up to $6,500 in annual catch-up contributions as well.
A company which uses a profit-sharing plan must include all employees and must use the same contribution formula for all employees. The IRS does allow some occasional exceptions to this rule, such as for employees who are very new to a company.
Two of the most popular employer retirement accounts are 401(k) and profit-sharing plans. Under a 401(k), individuals contribute money to their retirement account and receive a tax deduction for this contribution. Their employer may also make a contribution and receive a tax deduction.
Under profit-sharing, only the employer contributes to the retirement account. The employer establishes a uniform rule for how they contribute money to all employees’ retirement accounts. Then they receive a tax deduction for these contributions.
Tips on Retirement Planning
- Do you have questions about your retirement plans? Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Planning when you want to retire means you’ll need to have enough by then. With SmartAsset’s 401(k) calculator, you can review where your own retirement accounts stand. Then, you can figure out if you have some catching up to do.
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