There is a popular type of 401(k) plan called profit-sharing plans. 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 an “employer discretionary contribution” for this reason.
What is a profit-sharing plan?
Let’s define profit-sharing: In short, a profit-sharing plan is a type of defined-contribution plan that helps employees save for retirement while giving employers flexibility in designing key plan features.
In a profit-sharing plan, an employee receives a percentage of a company’s profits, either in cash or company stock, based on the company’s quarterly or annual earnings (and the amount is determined by the employer). Quarterly profit-sharing plans can be slightly more cumbersome, but they incentivize high-performers in risky businesses. The goal is to reward employees for their contribution to the business’ success and align their financial well-being with that of the company. Both pensions and profit-sharing plans achieve this goal.
Profit-sharing is a great way for owners to share business profits with the rest of the company and compensate them in a tax-friendly way — both employers and employees benefit from this approach. If you’re interested in setting up or learning more about a profit-sharing plan, or just have a few questions, feel free to reach out to our team!
How is a profit-sharing plan different than a 401(k)?
Is profit-sharing the same as a 401(k)? Short answer: No. While both plans give employees additional benefits, they follow different structures. The main difference from a “regular” 401(k) is that an employer has flexibility around making contributions to the employees. In a 401(k) that allows an employer match – employees can receive employer contributions as well as make their own contributions.
But in a profit-sharing plan, only employer contributions are permitted (i.e. an employee cannot make any contributions). A profit-sharing plan also has a different maximum contribution from a 401(k) (more below). While these differences are important, keep in mind that if a salary deferral feature is added, the plan would then be defined as a 401(k).
How does a 401(k) profit-sharing plan work? It simply allows employees to make contributions, and any employer contributions must stay within the general contribution limits established for profit-sharing plans.
Who can offer a profit-sharing plan?
A company of any size can offer a profit-sharing plan. A profit-sharing plan can be offered on its own or by a company that also offers another type of retirement plan. Lastly, a profit-sharing plan can be offered by a company that is NOT profitable. Profitability isn’t a requirement to offer this type of plan, and the flexibility that allows employers to adjust their contributions based on profitability is something many employers like.
However, only for-profit corporations can offer profit-sharing plans. For-profit companies, unlike non-profit organizations, are structured to create profits, even if they aren’t profitable every year. As a general rule of thumb, companies that can offer 401(k) plans can offer profit-sharing plans, too, or they can offer only profit-sharing plans. However, non-profit or not-for-profit companies that are eligible to offer 403(b) plans cannot offer profit-sharing plans. This is because these structures should not be pursuing profit.
How does a profit-sharing plan work?
A profit-sharing plan is a feature that is added to a normal 401(k) plan. In this arrangement, employers have flexibility in making contributions. Employers can offer but are not required to contribute matches to a 401(k) plan. In a profit-sharing plan, employers can contribute a set amount of percentage to all contributors — that amount is adjustable and purely at the employer’s discretion. Employers can change that amount every year. In fact, an employer can decide to contribute nothing at all in a given year to an employee’s profit-sharing plan. For example, if an employer does not make a profit in a given year, they do not have to make contributions that year (i.e. zero contributions). Because the company’s financial performance influences the employer’s decision to make a contribution one year but not the next, this is called a “profit-sharing” plan!
Here are some factors employers can consider when creating their profit-sharing plan:
- Employee eligibility: In this type of defined-contribution plan, an employer determines when and how much the company contributes to employees. The amount allocated to each employee is usually based on the employee’s salary level or rank within the organization. A profit-sharing plan typically includes all employees. However, some exclusion rules may apply, including age, service, nonresident alien status, or if they are part of a collective bargaining agreement that does not provide for plan participation.
- 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.
- From the employee’s point of view: Profit-sharing funds for each employee go into a separate account, and may include contributions of cash and/or stock. Some employee profit-sharing plans offer a combination of deferred benefits and cash, with cash being distributed and taxed directly at ordinary income rates (sort of like a retirement contribution plus an annual bonus). These profit-sharing combination plans give employees flexibility. Are profit-sharing plans qualified? Typically, contributions are made to a qualified tax-deferred retirement account that allows penalty-free distributions to be taken by a beneficiary after they reach age 59 1/2. The Federal Government and most state governments generally don’t tax contributions and earnings until they are distributed. Employees may be able to take loans from profit-sharing plans but depend on the plan rules. If an employee leaves a company, they can move assets into a Rollover IRA. The profit-sharing tax rate is in the employee’s control based on how they make withdrawals and rollover the funds throughout the account’s lifespan.
- When participants are eligible to receive a distribution: When plan participants reach this milestone, profit-sharing plans typically provide that participants can elect one of three methods:
- Participants can take a lump sum distribution from their account.
- Participants can roll over their account to an IRA or another employer’s retirement plan.
- Participants can take periodic distributions.
In the years when a company makes contributions in its profit-sharing plan, the company must come up with a set formula for profit allocation. The most common way to determine contributions in profit-sharing plans is referred to as the “comp-to-comp” method.
How is the individual employee allocation determined? What’s the maximum?
Let’s take a closer look at the 401(k) profit-sharing plan rules. If an employer makes contributions to a profit-sharing plan, they must have a documented, pre-determined type of profit-sharing allocation established for determining contributions. 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 total comp
- Employer contribution – The total amount the employer contributes to the whole profit-sharing plan
The math: The first step in the “comp-to-comp” method is where an employer calculates the sum total of all of its employees’ compensation. The employer then determines what percentage of the profit-sharing plan an employee is entitled to by dividing each employee’s annual compensation by the total comp. Then, to get the amount due to each employee, multiply the percentage by the total profit being shared. How much does an individual get in a profit-sharing plan? Employee comp fraction multiplied by the employer contribution determines the individual employee’s share of the employer contribution. The IRS sets the profit-sharing plan limits for 2019 contributions to the lesser of the following:
- 25% of the participant’s compensation, or
- $56,000 ($62,000 including catch-up 401(k) contributions) for 2019.
Just like with other tax-advantaged retirement accounts, the IRS can change the profit-sharing contribution limits. But the profit-sharing plan contribution limits give employers plenty of room to customize a plan to match their interests and their employees’ needs. The maximum amount of compensation that can be considered when determining contributions made to an employee in a profit-sharing plan is $280,000 in 2019. There is no typical profit-sharing percentage, but many experts recommend staying between 2.5% and 7.5%. Keep in mind that there is no set amount that must be contributed each year, but there is a maximum amount that can be contributed, which fluctuates with inflation.
Let’s look at a profit-sharing plan example. It’s based on two factors: the pool of money the plan will distribute, or a percentage of the company’s profits, and how the company organizes the distribution. Employers might create an equal distribution based on salary (ex. every employee receives a bonus equal to 10% of their salary), create distributions based on contribution (ex. different roles and personnel would receive different percentages), or other systems of dividing the pool of money. So long as the total amount falls within the contribution limits and the plan isn’t found discriminatory under the terms of ERISA’s nondiscrimination testing, the plan can move forward.
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. Profit-sharing plan tax deductions can be a significant benefit for companies who are growing. Using a profit-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 $56,000. 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?
For financially stable organizations, profit-sharing plans can serve as a powerful incentive for employees and owners alike. As is the case 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.
Many employers believe it will encourage employees to work harder or foster a sense of pride among employees from knowing that their efforts might help to lead to a profit-based contribution to their retirement nest egg. This type of plan requires considerable administrative upkeep, but 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: “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, and Integrated Plans
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: In this type of profit-sharing plan, contributions are not allocated strictly as a percentage of compensation. Instead, this plan type allows you to skew the profit-sharing allocation to specific employees. For instance, a qualified profit-sharing option that can have more substantial contributions for favored employees (usually higher-paid workers and key employees). This profit-share bonus scheme tends to works best when there are significant age and compensation differences between employees, i.e. you want to give a larger portion to some employees, based on their tenure, salary, etc.
- 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” or “integration” formula. This formula is designed to integrate the payments that the employer makes to the Social Security system with the allocations made to the retirement plan. An integrated plan 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).
Should I offer a profit-sharing plan to my employees?
There are several pros and cons to offering a profit-sharing plan, including whether you want or need flexibility in determining the size of the pool of money you’re going to pay out each year as well as how you might distribute money.
- A company can have a profit-sharing plan along with other retirement plans.
- Many employers like the fact that contributions are discretionary in a profit-sharing plan. Discretionary profit-sharing plans don’t commit them to certain dollar amounts, which is important if the company had a volatile year.
- A profit-sharing plan can be a good option for employers where cash flow is an issue.
- Many employers like that they can change how much they contribute each year.
- Many business owners use profit-sharing as a great way to save on corporate taxes, especially small business owners.
- Profit-sharing plans are flexible but can be complex.
- With a profit-sharing plan, there are NO restrictions on business size related to starting a profit-sharing plan.
- If an employer doesn’t want to design a profit-sharing plan from scratch, they can be bought off-the-shelf, e.g. from a financial institution or other retirement plan provider.
- Profit-sharing income helps employees prepare for retirement.
- To implement a profit-sharing plan, all businesses must take on administrative work, including filling out an Internal Revenue Service Form 5500 and disclosing all participants of the plan.
- The admin costs are often higher than other, more straightforward retirement plans, e.g. SIMPLE IRAs.
- An employer will still be subject to nondiscrimination testing to verify that the plan doesn’t favor highly compensated employees.
- Profit-sharing plans allow for employer contributions only; an employee can’t contribute.
- Finding information about how to offer and administer a profit-sharing plan can be a challenge because there isn’t a lot of clear information out there, specifically for the needs of small business owners who are interested in profit-sharing plans.
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 regarding 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?
Human Interest can help you with all of the steps above! 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.
Roles in a profit-sharing plan
- Employees. Employees are plan participants and eligible ones will be invited to participate in the plan. Employees are the recipients of employer contributions. Employees cannot make contributions to a profit-sharing plan for themselves. Employees may or may not have the ability to select or manage their investments. If an employee is in control of the investments in their account, it’s referred to as a “participant-directed plan,” and this arrangement may also limit liability of the employer. Sometimes the employer holds that responsibility as well as what investment options are available.
- Employers. Employers themselves conduct a lot of the calculations, planning, and paperwork (or work with providers who can help). They determine employee eligibility, plan details, contributions, and investment options. Each year, the employer determines how much of its profits it wishes to share as well as the profit-sharing formula it will use, which determines which employees get what, how much, and when (vesting). Employers are the only ones who can make contributions (employees are not eligible to make contributions). The employer is also responsible for setting up a system to track contributions, investments, distributions, etc., or partnering with a plan administrator to help. The employer also handles filing annual returns with the federal government (Form 5500), naming a trustee for the plan, hiring a plan administrator (if desired).
- Plan administrator. On behalf of the employer, plan administrations handle a lot of the administrative work involved in a profit-sharing plan. If you hired someone to help set up your plan, that arrangement also may have included help in operating the plan, including tracking participation, contributions, vesting, nondiscrimination/compliance testing, investing plan money, fiduciary responsibilities, disclosing plan information to participants, reporting to government agencies, etc.
- Plan fiduciary. The plan must designate a fiduciary, often the trustee. Fiduciaries are in a position of trust with respect to the participants and beneficiaries in the plan. Fiduciary responsibilities include 1) acting solely in the interest of the participants and their beneficiaries, 2) acting for the exclusive purpose of providing benefits to workers participating in the plan and their beneficiaries, and defraying reasonable plan expenses, 3) carrying out duties with the care, skill, prudence, and diligence of a prudent person familiar with such matters, 4) following the plan documents, and 5) diversifying plan investments. Many of the actions needed to operate a profit-sharing plan involve fiduciary decisions, e.g. managing or controlling the plan’s assets, providing investment advice, etc. The plan administrator may be the fiduciary who is providing investment advice. With fiduciary responsibilities, there is also some potential liability.
A note on compliance
Compliance is an important part of running a profit-sharing plan. Having an ongoing compliance review program makes it easier to spot and correct mistakes in plan operations. Keep in mind that to preserve the tax benefits of a profit-sharing plan, the plan must provide substantive benefits for rank-and-file employees, not just business owners and managers. Profit-sharing plans face requirements called nondiscrimination rules that compare both plan participation and contributions of rank-and-file employees to owners/managers. If you allocate a uniform percentage of compensation to each participant, then no testing is required because your plan automatically satisfies the nondiscrimination requirement.
How can I start a profit-sharing plan?
Keep in mind this isn’t a one-year endeavor. Profit-sharing plans must be established with the intention of continuing indefinitely.
- Determine profitability. The first step to figuring out what type of 401(k) plan to offer 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!
- Create a plan document. 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. They can help guide you in creating a written plan document outlining the terms and the day-to-day operations of the plan. The plan document will need to identify:
- the formula you will use to calculate contributions
- how contributions are deposited
- how you determine employee eligibility
- the vesting schedule, etc.
- Choose a trustee. An employer will need to arrange a trust for the plan’s assets. (A plan’s assets must be held in trust to ensure that assets are used solely to benefit the participants and their beneficiaries. The trust must have at least one trustee to handle contributions, plan investments, and distributions. Selecting the right trustee is an important step since they will ensure the profit-sharing plan remains financially secure.
- Choose a recordkeeping system. An employer will also need to develop a recordkeeping system. This system will help track participants and properly attribute contributions, earnings and losses, plan investments, expenses, and benefit distributions. A recordkeeping system will help you, your plan administrator or your financial provider prepare the plan’s annual return/report that must be filed with the Federal Government.
- Contact employees. The next step will be to provide plan information to eligible employees. You must notify employees who are eligible to participate in the plan about certain benefits, rights, and features. A Summary Plan Description (SPD), a plain-language explanation of the plan. Any time there’s a change to the plan, all participants must receive an individual benefit statement reflecting:
- the total plan benefits earned by a participant
- vested benefits
- the value of each investment in the account
- information describing the ability to direct investments, and
- for plans under participant direction, an explanation of the importance of a diversified portfolio
Terminating a profit-sharing plan
Sometimes profit-sharing plans need to be terminated, e.g. if you want to establish another type of retirement plan instead of a profit-sharing plan. Sometimes profit-sharing plans need to be terminated, e.g. if you want to establish another type of retirement plan instead of a profit-sharing plan. Human Interest offers both “regular” 401(k)s as well as profit-sharing. You can request more information here.