Both 401(k) plans and profit sharing plans are employer-sponsored retirement plans. But, what does it mean if an employer offers a profit sharing plan?
Simply put, a profit sharing plan allows employers to make a pre-tax contribution to eligible employees’ retirement accounts after the plan year ends, based on the funding formula described in the plan documentation.
So, what does that mean specifically? Let's take a look at profit sharing as one type of employer-sponsored retirement plan.
What is a profit sharing plan?
A profit sharing plan is a defined contribution plan that allows employers to make a contribution as a percentage of plan compensation or a flat dollar amount, depending on the terms of the plan document. Employers can decide how much to contribute based on the company's profits or other cash flows after the plan year ends. These plans provide employers with flexibility in the design of the plan, including fixed or discretionary contribution formulas.
How does a profit sharing plan work?
Companies of any size can offer a profit sharing plan, including non profit organizations. Because the profit sharing contribution can come from profits or other company cash flows, non-profit organizations may establish these plans, taking advantage of their flexibility to reward their employees. Employers do not necessarily have to make a profit in a given calendar year to offer or make contributions toward a profit sharing plan.
There are four common types of employer profit sharing contribution formulas:
- Pro-Rata Method: The pro-rata method establishes a fixed or discretionary percentage and applies that percentage to the employees’ compensation as defined in their plan documentation. For example, if the profit sharing percentage is 3%, the employer will make a 3% contribution based on each eligible employee’s salary.
- Flat Dollar Amount Method: The flat dollar amount method identifies a set dollar amount that is split evenly based on the number of employees participating in the plan. For example, if the employer sets aside $50,000 for profit sharing contributions and 25 employees participate in the plan, then each employee will receive a $2,000 profit sharing contribution.
- Age-Weighted Plan: Employer contributions correspond with the eligible employee's age. For example, the older an employee is, the greater the contribution.
- New Comparability Plan: New comparability profit sharing plans (also known as cross-tested plans) allow employers to structure different contribution rates for each employee while allowing the owner to maximize their personal contribution. However, as is typical across most retirement plans, the employer cannot favor highly-compensated employees in this type of profit sharing plan.
When considering a profit sharing plan, employers should consider the maximum contribution rules and tax deduction limits. In 2022, for example, employers may contribute up to 100% of the employee's salary, or up to $61,000, whichever is less.
Additionally, profit sharing contributions are also tax-deductible to the employer and aren’t subject to Social Security or Medicare withholding, meaning there are genuine tax benefits for offering a profit sharing plan.
What are the pros and cons of a profit sharing plan?
Pros of a profit sharing plan
Although flexibility is a primary benefit of a profit sharing plan for employers, there are multiple reasons why it’s a great time to start a company-sponsored retirement plan:
- A well-designed profit sharing plan can help organizations attract and retain top talent—which is especially critical in today's competitive market.
- Employees benefit from the investments within a profit sharing plan, allowing them to store up a nest egg. The employer contributions and pre-tax earnings grow on a pre-tax basis and are only taxed upon distribution.
- A profit sharing plan helps make employees at every level feel like owners, which improves performance within the organization. By inviting employees to share in the company’s success, the profit sharing plan may give organizations the buy-in to fuel company growth.
- Employees can take their vested money when they leave, easing administrative responsibilities for the employer while allowing employees to have more control over their retirement earnings.
Cons of a profit sharing plan
When considering a profit sharing plan, both employers and employees must consider any potential drawbacks. For employees, a discretionary profit sharing contribution formula implies that they may not receive a profit sharing contribution during specific years.
- Choosing the wrong profit sharing plan can lead to frustration among employees. For example, with the flat dollar amount method, one employee may believe that they deserve a higher profit sharing contribution based on their hard work than an employee who perhaps didn't put in as much effort.
- Numerous limitations on profit sharing plans exist. Although a profit sharing plan boasts flexibility for employers, their total contribution amount is capped, meaning an employer’s potential tax deduction is also capped. The Internal Revenue Service typically increases these limits annually, based on the cost of living. However, an employer must consider these limitations for cash flow, accounting, and tax purposes.
- Employers must consider the administrative costs of managing and overseeing a profit sharing plan. Although not as complicated as a traditional pension plan, profit sharing plans are often more expensive than simpler arrangements, such as a simplified employee pension (SEP) plan or a savings incentive match plan for employers (SIMPLE) IRA plan.
- If employers offer a new comparability profit sharing plan, they need to undergo annual testing to confirm that the plan does not discriminate in favor of their highly compensated employees. Of course, this can add expense and red-tape to the administration of the plan. Properly budgeting for a profit sharing plan can reduce any surprise billing, keeping costs at bay.
Is a profit sharing plan right for your business?
A profit sharing plan is a powerful tool for employers to attract and retain talent while giving their employees a sense of ownership and financial confidence—all while benefiting themselves financially with significant potential tax deductions.
When offering a profit sharing plan, employers should understand their objectives, know the retirement trends within their industry, and invest in employee communication and education, showing their employees the benefits of their profit sharing or 401(k) plan.
However, a more traditional 401(k) or 403(b) plan may be better for your business. Vestwell is a digital retirement plan platform that makes it easier for you to offer and administer a company-sponsored 401(k) or 403(b) plan. By combining technology with best-in-class retirement plans, Vestwell has created programs that are more accessible, more efficient, and less expensive.
Learn more about the best plan retirement program for your small business here.