Profit-sharing plans are retirement plans that allow companies to share profits with their employees. With this type of retirement plan, the employee receives a percentage of the company’s profits. However, this is based on how the company wishes to implement their profit-sharing plan.
Only employers contribute to profit sharing plans. If a salary deferral is added to a plan, it would then become a 401k plan. Similar to 401k plans, companies can make profit-sharing plans as simple or as complex as they want.
It can be dependent on the type of plan that they choose. Let’s review what profit-sharing plans are, how they work and some of the benefits.
What Is Profit-Sharing?
Profit-sharing is a good way for a business to share earnings, to also promote good employee morale, and to encourage hard work. How do profit-sharing plans work though? Are there different types that companies can utilize, and what are the pros and cons of these types of plans?
How Does Profit-Sharing Work?
You can be a business of any size to start a company profit sharing plan and there can be other retirement plans. In order to cut down on administrative headaches, you can purchase a pre-approved profit sharing plan document from a financial institution or benefits professional. There are some general rules that companies must follow with regards to profit-sharing plans.
From an employer perspective, if you can contribute a particular amount for any given year, you are allowed to do so. If you do not make any contributions for a specific year, that is also acceptable. Your business does not need to make a profit to make contributions to profit sharing plans. The form 5500 series return/report must be filed annually, it is required. Participant disclosures are also a requirement.
The “comp-to-comp” is a common method for determining each participant’s allocation in the profit sharing plan. Using this method will determine each employee’s share of the employer’s contribution. The total “comp”, or the sum of all of the employees compensation, is calculated by the employer.
Each employee’s allocation of the employer’s contribution is determined by dividing the employee’s “comp” by the total comp. Finally, you multiply each employee’s fraction by the total amount of contributions by the employer.
What about contribution limits for profit sharing plans? For these plans, the limits are the lesser of the following: 25% or 57k (for 2020). It is subject to cost of living adjustments in the future.
Types of Profit-Sharing Plans
There are three main types of profit-sharing plans that a company can utilize. Each of them come with different benefits based on the purpose of the business and the ownership. There are different plans to allow for flexibility for ownership and others to help retain talented employees.
If you make contributions to a profit sharing plan, they go into specific accounts for each employee. You will need to have a formula determining how the contributions are divided. This is determined by the type of profit-sharing plan that you employ:
- Age-weighted plan: Feature contributions that correspond to equivalent benefits of retirement age. The older an individual employee is, for example, the higher their contribution percentage will be. This is a useful tool for retaining talented employees. Given their contribution limit rises, there is incentive to stay with the company
- Pro-rata plan: Everyone receives the same rate of contributions from the employer. It works similarly to an employee match in that everyone gets the same percentage of their compensation, as an employer contribution
- New comparability plan: This is the most flexible plan for owners who want to receive the maximum contribution amount. While at the same time, they are contributing to employees at different rates. By placing employees into a different benefits group, employees will get a smaller amount. At the same time the owners would receive the maximum contribution. An example would be older ownership with a much younger employee base
What Is a 401k Profit-Sharing Plan?
A profit-sharing plan allows an employer to contribute up to $57,000 per year into the employees account. Employees cannot make contributions to this account at all. Compare this with 401k where the employee contribution limit is $19,500 (as of 2020). With a 401k there could be an employer match as well.
A 401k profit-sharing plan is similar to a 401k plan. Except in place of an “employer match”, there is a contribution that is based on the health of the company. A typical 401k plan with a company match allows the company to have a set percentage of the employee’s compensation. This is regardless of how well the company does in a particular year.
With a 401k profit-sharing plan, the employer will contribute an amount to the employee’s 401k based on how much profit the company had made in that year.
Pros and Cons of Profit-Sharing Plans
Like any retirement plan, there are always benefits and drawbacks. Profit-sharing plans are no different in this case. There are pluses and minuses from both the employer and employee perspective. Let’s review them both.
Pros of Profit-Sharing Plans
Profit-sharing plans provide both the employers and employees with benefits. If everything is going well within a particular company, profit-sharing can be a good morale boost and provide additional income. Some of the other pros are listed below:
Pros:
- Employers:
- Contributions are strictly discretionary and are flexible (no government requirements)
- This is a good plan If cash flow happens to be an issue, employers do not have a minimum contribution requirement
- Employees:
- This is another source of money outside of your base income
- Promotes hard work, if the company does well you are compensated more
Cons of Profit-Sharing Plans
Profit-sharing plans offer some downsides from an employer aspect, but also could be seen as such from the eyes of an employee. If employee’s expectations are not met and they have worked extremely hard through the year, there may be some issues. Some of the other cons are listed below:
Cons:
- Employers:
- Administrative costs may be higher than with other plans, such as with a SEP or SIMPLE IRA plans
- Employers need to ensure that the higher compensated employees are not benefited more as to not create employee conflict
- Employees:
- There could be low employee morale if they get less than expected with profit-sharing. This is especially true if employees experienced a particularly tough work year
- In-service withdrawal: There is a 10% early withdrawal penalty if taken prior to 59.5 years of age
Consider Guidance From a Financial Advisor
Profit-sharing plans can be a great incentive for employees to share in a company’s success, to work hard, and to stick around at a company longer term. For employers it provides much needed flexibility in times that are tough, and a way to retain employees and keep them engaged. There are some potential downsides to these plans as well.
If there are any questions or concerns surrounding profit-sharing plans and what they could offer to a company, contacting a financial advisor is a wise decision.