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Profit-Sharing: How is it Different from a Regular 401(k)?

By Vijay Mirpuri

As a feature of a 401(k) plans, there is a popular option called profit sharing. The main difference from a “regular” 401(k) is that an employer can make an employer profit-sharing contribution to eligible participants — compare this to a typical employer match, in which only employees who are making their own employee contribution can receive employer contributions (that’s why it’s called a “match”!). Profit sharing is also called, “employer discretionary contribution” for this reason.

Profit sharing is a great way for owners to generously share business profits with the rest of the company and compensate them in a tax-friendly way — both employers and employees will benefit from this approach.

If you’re interested in setting up a profit-sharing plan, or just have a few questions, feel free to reach out to our team!

The definition of profit sharing

A profit-sharing plan is simply a feature that is added to a normal 401(k) plan: it is a defined contribution plan option in which the employer is granted responsibility for determining when and how much the company contributes to the plan. The amount allocated is usually based on the employee’s salary level or level within the organization.

Unlike a regular 401(k) plan, companies aren’t required to contribute a set amount; instead, the amount is purely by the employer’s discretion. Other factors (e.g., the company’s financial performance), may also influence the employer’s decision to make a contribution one year but not the next, which is why it’s called a “profit-sharing” plan!

Many business owners use profit-sharing as a great way to save on corporate taxes as well as to reward and motivate employees. Many of our small business clients told us they felt a bit lost because there isn’t a lot of clear information out there when it comes to profit-sharing, specifically for the needs of small business owners, so we wrote this guide to explain exactly what it is and how it works.

How is the individual employee allocation determined? What’s the maximum?

If an employer makes contributions to a profit-sharing plan, they must have a documented, pre-determined type of profit-sharing allocation established and in use for determining how the contributions are divided.

According to the Internal Revenue Service, a standard method for determining each participant’s allocation in a profit-sharing plan is the “comp-to-comp” method:

  • Total comp – The employer calculates the sum of all of its employees’ compensation
  • Employee comp – An individual employee’s compensation
  • Employee comp fraction – Employee comp divided by the total comp
  • Employer contribution – The total amount the employer contributes to the whole profit-sharing plan

How much does an individual get in the profit-sharing plan? Employee comp fraction multiplied by the employer contributiondetermines the individual employee’s share of the employer contribution.

The IRS sets the contribution limit to the lesser of the following:

  • 25% of the participant’s compensation, or
  • $54,000 ($60,000 including catch-up 401(k) contributions) for 2017.

One-time, end-of-year contribution: The easiest and most common way to do a profit share is as a one-time end-of-year contribution from your draws. After the year ends and you figure out your company’s earnings, you’d decide how much you want the company to contribute to each of your employees’ retirement savings. You’ll have until the corporate tax filing deadline (March 15) to make these contributions for the previous year.

Will profit-sharing reduce my company’s or my employees’ tax bills?

The short answers are: yes and yes. Contributions and earnings generally aren’t taxed by the Federal Government or by most state governments until they are distributed. Using a profot-sharing to defer some of this income can save significant tax dollars for small business owners, and help them reach the annual tax deferral limit of $53,000.

This makes it so that the tax considerations of a profit-sharing plan are very similar to the tax advantages of a 401(k), but with slightly more control over allocation of funds (and therefore tax savings) given to the employer, as opposed to the individual employee in a typical 401(k) plan, where they can contribute as much or as little as they want (within federal limits).

Why do employers offer profit-sharing?

Like with a 401(k) plan, many employers use a profit-sharing plan to recruit and retain employees, in addition to the great tax benefits for both the employer and employees. It’s a plan that serves to reward all employees as well as owners and managers, which is a great motivator and concrete way to thank everyone for contributing to the business’s overall success.

This type of plan also offers great flexibility for employers because the amount—and act of contributing— is at the employer’s discretion and can be adjusted based on cash flow. Research indicates that profit-sharing plans are increasing in popularity; 21% of the organizations in a survey conducted by WorldatWork said they used profit-sharing plans.

Here is an interesting article on FastCompany that describes an example case: “A little over a year ago, Tower Paddle Boards started letting employees leave by lunchtime and offering 5% profit-sharing.”

Custom profit-sharing 401(k) plans

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Custom options: New Comparability, Age-Weighted, Integrated, and Flat Dollar

There are a few “special” types of the profit-sharing feature that are less common but are still an option, depending on your needs. These approaches are particularly useful to those looking to specifically segment out who they want to give profit-sharing contributions to:

New Comparability A qualified profit-sharing option that can have more substantial contributions for favored employees (usually higher-paid workers and key employees). With this type of plan, contributions are not allocated strictly as a percentage of compensation. This type of plan lets you skew the profit sharing allocation to specific employees. It works best when there is a significant age and compensation difference for employees that you want to give a larger portion of the employer contribution pie vs. other employees.

Age-Weighted An employer may add an age-weighted feature, which allocates a higher percentage of plan contributions to older employees. The assumption is that older employees have less time before they retire and therefore less time to accumulate retirement savings. Age-weighted plans are suitable for business owners who are considerably older and are higher compensated than their other employees and who may not have had the opportunity to accumulate retirement savings in their earlier years.

Integrated Plan For employers seeking to provide an extra benefit to certain individuals without the additional administrative costs and testing requirements of cross-testing, a good alternative is to utilize a permitted disparity allocation formula. This formula is also commonly referred to as “integration”, in that it is designed to integrate the payments that the employer makes to the Social Security system with the allocations made to the retirement plan. Integration lets those employees whose compensation is in excess of the Social Security taxable wage bases get an additional allocation (keep in mind that Social Security has a compensation cap).

If you have questions about these, leave a comment below or contact us and we can help with your specific questions.

Should I offer profit-sharing?

The U.S. Department of Labor provides a helpful list of questions for employers to consider if they are looking at whether or not to set up a profit-sharing plan:

  • Have you decided to hire a financial institution or retirement plan professional to help with setting up and running the plan?
  • Have you adopted a written plan that includes the features you want to offer, such as whether contributions will be discretionary, how contributions will be allocated and when they will be vested?
  • Have you notified eligible employees and provided them with information to help in their decision-making re: making their 401(k) contributions?
  • Have you arranged a trust for the plan assets?
  • Have you decided how much to contribute to the plan this year?
  • Are you familiar with the fiduciary responsibilities?
  • Are you prepared to monitor the plan’s service providers?

Source: profit-sharing Plans for Small Businesses, U.S. Department of Labor

Human Interest can help you with all of the steps above!

The first step is to make sure you’re profitable, and that you’re confident that you will continue making money for at least the next few years—you don’t want to create and announce a plan one year, only to not be able to make contributions the next year! Once you’re ready to begin the process, be sure to contact legal and financial advisors who have experience creating profit-sharing plans and who can help you navigate the regulatory requirements and fiduciary responsibilities.

Much of employee performance is linked to how devolved they feel to the organization. Employees may be encouraged to work harder—as well as gain a sense of pride—from knowing that their efforts might help lead to a profit-based contribution to their retirement. For financially stable organizations, profit-sharing plans can serve as a powerful incentive for employees and owners alike.

Human Interest offers both “regular” 401(k)s as well as profit-sharing. You can request more information here.

Image credit: Luis Llerena