Types of Profit Sharing Plans
posted by Fisher 401(k) January 30, 2019
Small businesses choose to add profit sharing to their 401(k) plan because they want to contribute to employee retirement accounts, but also want to control these contributions based on how well their business did in the year. Let’s take a look at some of the other reasons to add profit sharing to your company's 401(k), as well as some of the considerations to make and steps to take if you decide a profit sharing option might be right for your business.
How Do Profit Sharing 401(k) Plans Work?
Profit sharing 401(k) plans work like this: A business sets aside a portion of its pre-tax profits to contribute to their employees’ retirement accounts. Business owners can award that money to their employees as a percentage of their salary or as a set dollar amount. For profit sharing 401(k) plans, the yearly contribution limit is $56,000 per employee (or 100% of their salary, whichever amount is lower). Profit sharing can be added to a 401(k) plan with a simple plan amendment.
Why Add Profit Sharing to your 401(k) Plan
Add an Employer Match and Control Costs. The amount you contribute is completely up to you, so you have the ability to do what makes the most sense for your business. You can also divide employees into distinct eligibility groups, giving you the flexibility to contribute at different rates for different sets of employees based on a pre-determined allocation formula.
Add Profit Sharing to Attract and Retain Talent. As of 2016, the average employer contribution in a profit sharing plan is 4.8% of an employee’s salary.1 Using this as a baseline, you can choose to give certain employee groups a higher contribution rate in order to attract and retain top talent. Additionally, just like with a traditional small business 401(k) plan, you can set up your vesting schedule to determine how long an employee must work for your company before they own 100% of the profit sharing contributions you make.
- Lower your Tax Liability. As with other types of 401(k) plans, all your contributions to a 401(k) plan with profit sharing plan are tax deductible. However, if you’re looking to lower your small business’ taxable income in more profitable years, profit sharing 401(k) plans can help you make the highest possible contributions to get the highest possible write-off. That’s because these plans have a much higher maximum employer contribution limit: In 2019, it’s $56,000 per year (or $62,000 for employees over the age of 50), or 100% of the employee’s total income, whichever is lower.
Types of Profit Sharing Plans
There are three primary types of profit sharing plans: the pro-rata plan (the most common), new comparability plans (the most flexible), and age-weighted plans (most helpful for retaining talent). By thinking about profit sharing contributions in terms of employee age, importance to your company, and your business goals, you can choose the one that will work best for your business. Here are the details of each:
A pro-rata plan is one where everybody in the plan receives employer contributions at the same rate. It works similarly to an employer match, in that every employee receives a percentage—in this case, the same percentage for each employee—of their compensation as an employer contribution. For employers who want simplicity, but are interested in adding an additional benefit, this is a great choice.
New comparability profit sharing (sometimes called “cross-testing”) offers the most flexibility for owners who want to personally receive the maximum possible contribution, or who want to be able to make contributions to employees at different rates. By placing employees into separate benefit groups, owners can get the maximum percentage contribution while other employees get a smaller amount. Generally speaking, cross-testing works best with older owners and a younger employee base.
Age-weighted profit sharing plans feature contributions that correspond to equivalent benefits at retirement age. In other words, the older an employee is, the higher percentage contribution they’ll receive. This is a good option for employers primarily concerned with retaining talent; the longer someone stays with the company, the more their employer contribution rate will increase.
Keep in mind that there are pros and cons to adding a profit sharing plan to your 401(k). For example, there could be fluctuations from year to year in terms of profitability, which could make it tough on morale if employees get a lower compensation than expected.2 Talk to your provider about these and any other drawbacks, and ask if the advantages of profit sharing outweigh the disadvantages for your business.
The best profit sharing plans align with a company’s goals to make Profit Sharing and 401(k) plan administration easier into the future. Plan well, think through your vision for the future of your plan and company, and find a trustworthy partner to establish a profit sharing 401(k) plan that gives employees a real benefit, as well as an incentive to give you their very best work as your company continues to grow and thrive.