What Is a Profit-Sharing Plan — and Why Should Employers Explore This Retirement Option?

Confusion around 401(k)s is common. In fact, 63% of people in the U.S. say they don’t understand how 401(k)s work. Business owners aren’t immune from this confusion — especially because they should have a more-than-basic understanding of these common retirement vehicles.

Most employers understand the two basic contribution types for 401(k)s: Employees can contribute by taking money out of their paychecks, and employers can match employees’ contributions to their retirement accounts.

What many employers often aren’t aware of, however, is a third game-changing method: profit-sharing. How do profit-sharing contributions work in your 401(k)? Essentially, they allow companies to contribute additional pretax funds into employees’ retirement accounts after the end of the year. As a term, “profit-sharing” is a bit confusing given that in this specific situation, it’s not tied to a company’s profits. This isn’t to say that it can’t be or that contributions don’t affect a business’s bottom line, but there’s no required formula for profit-sharing. It’s a discretionary decision left to the company that doesn’t have to relate to the organization’s actual performance.

For the most part, profit-sharing contributions are used by business owners to put more money into their own 401(k) accounts while taking advantage of some tax benefits. In 2022, the 401(k) plan contribution limit is $ 61,000, including employer and employee contributions. For employees 50 and older, that number is $ 67,500. However, only $ 20,500 can be contributed pretax from an employee’s paycheck, so employer contributions must make up the difference.

Although matching is a common way to help employees get closer to those contribution limits, implementing a company profit-sharing plan is the best way to fill up the entire 401(k) bucket — and employers and employees alike can take advantage of the benefits of profit-sharing.

The Benefits of Profit-Sharing Contributions

It’s up to you, the employer, to determine who will be eligible for profit-sharing plan contributions to retirement accounts. You could decide to focus your attention on the leadership team, for example. With most profit-sharing plans, however, some money must also go to employees when the benefit is given to executives. We’re not talking chump change here, but a solid amount to those in your ranks. The reason comes down to annual Department of Labor testing.

Profit-sharing contributions offered to those outside of the leadership team must be proportional to the amount given to owners, executives, and managers. This is usually on top of — and not a replacement of — any match or contribution your company typically gives. So a company profit-sharing contribution is a big benefit to your employees, not to mention a benefit that might help you recruit and retain workers in a tough labor market.

The benefits of profit-sharing are substantial for businesses, too. Aside from a retention tool, profit-sharing contributions are tax-deductible. They’re not subject to payroll taxes, so making contributions can lower your taxable income. In a profitable year, that can mean a lot of savings for your company. What’s more, profit-sharing plans allow you to decide how much to contribute to employees’ retirement accounts. If the company has a bad year, for example, then you can contribute less, and vice versa.

Arriving at the Right Profit-Sharing Program for Your Employees

Despite the benefits, the decision of whether to implement a profit-sharing plan should not be taken lightly. Before planning on the scope and structure of your company’s profit-sharing plan, ask yourself the following questions:

1. How much cash flow will I utilize for profit-sharing?

Once you make profit-sharing plan contributions, that money is out of your company’s accounts. By no means can you claw a single dollar back. Therefore, timing is key. You can contribute at any time prior to the corporate tax filing deadline. Those funds will then be allocated to the previous plan year.

2. Should certain employees benefit more than others?

An often-forgotten benefit of profit-sharing contributions is their flexibility. You can design contributions in order to tie them back to performance goals. If employees enter the year with this understanding, then the financial reward will undoubtedly incentivize and motivate team members to perform at higher levels. You also always have the option of offering greater benefits to high performers. This, too, can serve as a performance motivator for next year, encouraging employees to keep up the good work.

3. Will I provide more than the minimum benefit to employees?

Generally speaking, the minimum benefit is a decent contribution, and most businesses that offer profit-sharing contributions to employees give only the Department of Labor’s required amount. It’s already on top of a regular 401(k) account contribution, after all. Remember, you’re also paid along with your employees, so you must decide whether to max out the amount allowed for your retirement plan contributions. Do you and other executives want to benefit as much as possible for the year? Will that decision impact employee profit-sharing plans?

Deciding to make profit-sharing plan contributions is a big commitment, but it can differentiate your organization from the rest of the pack. Few companies offer profit-sharing programs for employees. Make a big deal about the benefit, and take the time to explain that it’s a token of your gratitude for employees’ work throughout the year. The gesture will not be forgotten and can go a long way to support your retention efforts for years to come.

Are you wondering whether you’re making the right financial decisions for your company’s future? Take Plancorp’s assessment today.

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Author: Matt Baisden

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