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

In addition to 401(k) plans, there is another defined contribution workplace retirement plan known as a profit sharing plan. Like 401(k) plans, profit sharing plans are employer-sponsored retirement plans that are subject to federal laws and protections. But they differ from 401(k)s in a few key ways! The main difference is who can contribute to the plan, but there are also differences in the way investment limits are calculated and the circumstances in which this plan would be a good fit.

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 a profit sharing plan

A profit sharing plan is a defined contribution plan 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 401(k) plan, a profit sharing plan does not allow employees to make contributions: the plan only accepts contributions from the employer. Companies aren't required to contribute a set amount; instead, the amount is based on their 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 formula 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 contribution determines 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 contributions) for 2017; $53,000 ($59,000 including catch-up contributions) for 2016.

In other words, in 2017 an employer will be able to completely max out an employee's limit as long as the employee's comp exceeds $216,000.

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 a profit-sharing plan reduce my tax basis?

Contributions and earnings generally aren’t taxed by the Federal Government or by most state governments until they are distributed. Using a profit-sharing plan 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 a profit-sharing plan?

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 Plan, Age-Weighted Plan, Integrated Plan, Sole Proprietors

There are a few "special" types of profit-sharing plans that are less common but are still an option, depending on your needs:

New Comparability Plan
A qualified profit-sharing plan 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.

Age-Weighted Plans
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 than their 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.

Self-Employed (Solo) Business Owners
You can make contributions on behalf of yourself only if you have net earnings (compensation) from self-employment in the trade or business for which the plan was set up. Your net earnings must be from your personal services, not from your investments. If you have a net loss from self-employment, you cannot make contributions for yourself for the year, even if you can contribute for common-law employees based on their compensation.

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

Should I offer a profit-sharing plan?

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?
  • Have you arranged a trust for the plan assets or will you set up the plan solely with insurance contracts?
  • Have you developed a recordkeeping system?
  • 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?
  • Are you familiar with the reporting and disclosure requirements of a profit sharing plan?

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 plans. You can request more information here.

Image credit: Luis Llerena