The American retirement system is often referred to as a three-legged stool because there are three parts to government programs, such as Social Security, an individual's private savings and the benefits of any plans that have been sponsored by their employer(s), such as a profit sharing plan. 401k plans can be established as profit sharing plans.
What is a Profit Sharing Plan?
A profit sharing plan is one that is established and maintained by an employer to provide for the participation in his profits by his employees or their beneficiaries; this is the most common type of defined contribution plan. The plan provides for a definite predetermined formula for allocating contributions made to the plan. The amount of the employer's contribution can be determined by the formula, or through the employer's discretion within federally mandated limits. However, contributions may not discriminate in favor of highly compensated employees. These plans must feature recurring and substantial contributions from the employer's profits.
What is a 401k?
A 401k is a type of profit sharing plan that is also qualified under the Internal Revenue Code. In a 401k plan, each participant has her own account and generally selects her investment vehicles. The employer's contributions are considered deferred compensation, and are not included in the participant's taxable income in the year in which it is contributed to the plan.
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Must an Employer Distribute All Profits Through the Plan?
While plans must feature recurring and substantial contributions from the employer's profits, the employer is not required to distribute all of his profits through the plan. Since the qualified retirement plan system is a voluntary one where employers may or may not offer these benefits to their employees, no employers would participate in the system if they were required to distribute all profits to their profit sharing retirement plans. Congress seeks to achieve a balance in regulation and law in this area, encouraging employers to offer these plans, while enacting enough laws and regulation to protect the participants and beneficiaries.
What Happens if There are No Profits?
Section 401(a)(27) of the Internal Revenue Code explains that contributions are not required to be based on the employer's profits, whether current or accumulated. This gives the employer an opportunity to share with employees her profits, but money can still be contributed to the plan in the event there are no profits.