A profit-sharing plan is one kind of retirement plan an employer may offer its employees. It allows the company to share part of its profits with its employees, thus giving them a sense of ownership.
This type of plan can be very lucrative for employees, though the employer has sole discretion in how and when contributions to the plan are made.
So, how exactly does profit sharing work, and how can it benefit you? Keep reading as we dive into the details of profit-sharing plans.
What Is A Profit Sharing Plan?
So, what is profit sharing, and how does it work? Profit-sharing plans are retirement plans that allow for discretionary employer contributions.
Any plan allowing employee contributions does not qualify as a profit-sharing plan. Since the company allows the employees to share in the company profits, there is a chance that there could be zero contributions in some years. In other years, there may be significant contributions.
- The amount and timing of the contributions are entirely up to the company. Small business owners often offer this type of plan to eligible employees, and it can really pay off if the business grows and becomes highly profitable.
These plans can be great ways for employees to grow their retirement savings, but there are often stringent rules regarding a vesting schedule and early withdrawal penalties.
- The business must use a set formula for determining the profit allocation. This prevents the company from unfairly discriminating against lower-paid employees. This is generally spelled out in the profit-sharing agreement. You may also hear these plans referred to as a deferred profit-sharing plan, or DPSP.
The most common method of allocating profits is the comp-to-comp method. This essentially allocates the company’s earnings based on the employee’s annual compensation ratio to total company salaries.
KEY TAKEAWAYS
- A Profit-sharing plan is one where a business uses a set formula to determine profits that will be allocated to employees.
- The most common method for allocating profits is the comp-to-comp method, where employees receive a pro-rata portion based on their compensation compared to the total company salary.
- Profit-sharing plans can be significant benefits for employees, with all contributions being made by the employer.
Traditional 401(k) vs Profit Sharing 401(k)
A traditional 401(k) allows employees and employers to contribute. The employee makes tax-deferred contributions to the plan, and those contributions grow tax-free until retirement age. Upon reaching full retirement age, the employee makes withdrawals and pays regular income taxes on the distributions.
The profit-sharing retirement account is a little different. It is not a 401(k) at all. While an IRA and a 401(k) are similar, the profit-sharing plan differs in a few respects.
- In fact, no employee contributions are allowed into a profit-sharing plan. While it is still considered a defined contribution plan, only the employer may make contributions, and the employer makes all the decision-making regarding contributions.
- Eligibility to participate in profit-sharing is relatively broad. In fact, any business can choose to implement this plan and add it to its employee benefits.
- It also has wide discretion in how to implement the plan as long as it does not discriminate against employees.
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Benefits Of Profit Sharing Plans
These plans offer great tax benefits to both employees and employers. The employer’s contributions are tax deductible in the current year, and the plan’s earnings can grow tax-free.
In addition, this is a great retirement benefit that can be used to attract and retain talent to your organization. It is a great way to add to an employee’s compensation when the company’s profitability is high.
Another benefit is that the company is not required to contribute to the plan in years with low profitability. The plan documents will specify precisely when and how contributions are made, but the employer must set all those rules.
Profit-sharing contributions are typically only made in the years the company makes money. Otherwise, there is no profit to share.
Having a written plan and a good record-keeping system is a great way for a company to ensure it is following the IRS rules and meeting the nondiscrimination requirements.
TIP
A Profit-Sharing plan can be a great way to engage and incentivize employees. It allows an employee to participate in the business’s success without requiring them to contribute.
Profit Sharing Plan Rules & Contribution Limits
If your company is considering implementing a profit share plan, you should know the rules. Some Internal Revenue Service and Department of Labor rules must be met.
First, any company can implement this type of plan. They need to complete IRS Form 5500 and provide disclosures to all plan participants. The company should also choose a financial institution as a fiduciary plan administrator.
There are also some limits on contributions. Your employer can place no more than $69,000 or 100% of your compensation into the plan during the year, whichever is less. However, the employer can only deduct contributions up to 25% of the employee’s compensation. In addition, only $345,000 of an employee’s salary may be considered for a profit-sharing plan.
The Bottom Line
Profit-sharing plans are great retirement benefits offered by some companies to their employees.
These profit deferral plans only allow employer contributions, and the employer has great flexibility in setting the rules for the plan. The period of time in which they make contributions can be annually or quarterly, although annual contributions are much more common.
Plan participants typically receive a lump sum payment into their account each year based on the company’s profitability for that year.
Frequently Asked Questions
Yes, profit sharing is usually good for employees. Similar to a cash balance plan, it can help boost employee morale and performance.
Profit sharing can also help retain employees. It is a great way for an employee to grow his or her retirement savings.
The value of the plan’s assets varies based on the company’s profit in a given year, and employers are not required to make contributions each year.
A profit-sharing plan offers significant tax advantages for both the employer and the employee. The employer contributions are tax deductible for the business.
In addition, the plan’s investments can grow tax-free, and the employee owes no taxes on these dollars until reaching retirement age.
Finally, these plans give employers flexibility. They can decide how much to contribute and are not required to make a contribution at all each year.
While the two are very comparable, there is one significant difference. Both employees and employers can contribute to a 401(k).
However, employee contributions are not allowed with a profit-sharing plan. Only employers may contribute to these types of plans.
This is similar to the difference between a pension and a 401(k). Pensions are usually funded entirely by the employer. Employees may contribute to a separate 401(k) or IRA or utilize a backdoor Roth IRA strategy.
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