A profit sharing plan is one kind of retirement plan that an employer may offer its employees. It allows the company to share part of the company’s profits with its employees thus giving them a sense of ownership in the company. This type of plan can be very lucrative for employees, though the employer has sole discretion in how and when contributions into 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 profit sharing work? Profit sharing plans are a type of retirement plan that allow for discretionary employer contributions. In fact, any plan that allows for 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 is completely up to the company. This type of plan is something that small business owners often will offer 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 very strict rules when it comes to a vesting schedule and early withdrawal penalties. Additionally, 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 way to allocate profits is the comp-to-comp method. This essentially allocates the company’s earnings based on the ratio of the employee’s annual compensation to total company salaries.
Traditional 401(k) VS Profit Sharing 401(k)
A traditional 401(k) allows both employees and employers to make contributions. The employee makes tax deferred contributions into 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.
First, the profit sharing account is not a 401(k) at all. While an IRA vs 401k are similar, the profit sharing plan is different 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 all the decision-making for contributions lies with the employer. Eligibility to participate in profit sharing is fairly wide. In fact, any business can choose to implement this plan and add it to their employee benefits. They also have wide discretion in how to implement the plan as long as it does not discriminate against employees.
Benefits Of Profit Sharing Plans
These plans offer some great tax benefits to both employees and employers. The contributions made by the employer are tax deductible in the current year, and the earnings in the plan 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 profitability of the company is high.
Another benefit is that the company is not required to make contributions to the plan in years where profitability is low. The plan documents will spell out exactly when and how contributions are made, but the employer gets to set all those rules. Profit sharing contributions are typically only made in years in which the company makes money. Otherwise, there is no profit to share. Having a written plan in place along with a good record-keeping system is a great way for the company to ensure it is following the IRS rules and meeting the nondiscrimination requirements.
Profit Sharing Plan Rules & Contribution Limits
If your company is considering implementing a profit share plan, you should become familiar with the rules about these plans. There are some Internal Revenue Service and Department of Labor rules that must be met. First, any company can implement this type of plan. They simply need to complete IRS Form 5500 and disclose all participants of the plan. The company should also choose a financial institution to act as a fiduciary plan administrator.
When it comes to contributions, there are some limits there too. Your employer can place no more than $58,000 or 25% of your compensation into the plan during the year, whichever is less. In addition, only $290,000 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 for 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 profitability of the company for that year.
Frequently Asked Questions
Is profit sharing good for employees?
Yes, profit sharing is usually good for employees. Similar to a cash balance plan, it can help boost employee morale and performance. In addition, it can help retain employees. Profit sharing provides a great way to help an employee grow his or her retirement savings. The value of the plan’s assets varies based on how much profit the company experiences in a given year, and employers are not required to make contributions each year.
What are the advantages of profit sharing?
A profit sharing plan offers a big tax advantage for both the employer and employee. The employer contributions are tax deductible for the business. In addition, the investments in the plan 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 of a contribution to make, and they are not even required to make a contribution at all each year.
What is the difference between a 401k and profit sharing?
While there is a lot of comparability between the two, there is one major difference. Both employees and employers can contribute to a 401k. However, employee contributions are not allowed with a profit sharing plan. Only employers may contribute to these types of plans. This is a similar difference when you compare a pension vs a 401k. Pensions are usually funded completely by the employer. Employees may contribute to a separate 401k, IRA, or utilize a backdoor Roth IRA strategy.