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Retirement Planning: 401K Versus Profit Sharing

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Authored by Casey Quinn in Investments
Published on 01-17-2009

No one wants to work forever; working is just a means to an end. Where, but more importantly when, is the end of the road? It all depends on your retirement plan. Learning the basics of retirement options will help you come up with an overall strategy to live the good life of retirement. Two common retirement plans offered by employers include the 401K plan and a profit sharing plan. Here are the basics of each to make sure you know what to expect when you are ready to retire.

The most popular retirement plan offered by employers these days is the 401K plan. The best part of the 401K plan as an avenue to save for retirement, is the tax benefits. Unlike other options available, most 401K plans are contributed by workers pre tax – meaning it comes out of your paycheck and the amount contributed is not hit with income tax. This break allows workers to contribute more money without really noticing a large impact on the amount they receive in their paycheck.

The money is generally directly deposited based on a set percentage of the workers paycheck. The funds are then invested in a wide range of investment options depending on the company’s plan. Many companies offer matching plans where a certain percentage of your contributions are matched by the employer. The 401K investment grows untaxed. This includes any interest, dividends or even capital gains you might have while your money is shielded inside the plan. Tax free growth benefit of the plan is unlike anything investment you may have in your portfolio. Over time your money grows without tax repercussions reinvesting any gains you have. This allows for exponential growth until you begin withdrawing the money in retirement.

As an alternative to a 401K plan, some companies offer profit sharing plans. These plans are more performance based investments where workers are given a certain amount of company shares. Each share is worth a set amount of money based on targets or goals the company sets each year. If the company meets all of their goals, the worker receives a set amount of money for each share they hold. Typically workers will receive more shares based on performance and tenure. The profit sharing plan shares hold no value once you are no longer employed with company. You only receive the benefits of the profit sharing while working. If the company does not perform well, the worker will receive less money than if they outperformed their goals that year.

The main benefit of this plan comes with a major drawback. All of the money invested comes from the company (which is a good thing). However the worker cannot contribute to this type of plan (which is a bad thing). Since the only way to get money into the plan is from the shares, this limits the total amount the retirement plan can have in it. You can only have in your retirement plan what they put in.

401K plans provide a consistent retirement option allowing money to grow tax free and contributed by both the worker and the company. Profit sharing plans depend on the overall success and health of the company for the worker to get the most out of the plan.

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