What Is a Profit-Sharing Plan, and Should Employers Consider It?

January 14, 2022

There is a lot of misunderstanding about 401(k)s. In reality, 63 percent of Americans believe they have no idea how 401(k) plans function.

Business owners aren't immune to this perplexity, particularly because they should know more than the basics about these prevalent retirement vehicles.

Most companies are familiar with the two fundamental forms of 401(k) contributions: workers may contribute by deducting money from their paychecks, and employers can match their employees' contributions to their retirement plans.

However, many employers are unaware of a third game-changing strategy: profit-sharing. In your 401(k), how do profit-sharing contributions work?

Essentially, they let employers to make extra pretax contributions to their workers' retirement accounts after the year ends. The phrase "profit-sharing" is a little misleading since it isn't related to a company's revenues in this case.

This isn't to suggest it can't be done, or that donations have no impact on a company's bottom line, but profit-sharing has no set formula. It's a choice made at the company's discretion that doesn't have to do with the organization's real success.

Profit-sharing contributions are often utilized by company owners to increase their contributions to their own 401(k) plans while also receiving tax advantages. In 2022, the maximum contribution to a 401(k) plan, combining company and employee contributions, will be $61,000.

This figure is $67,500 for workers 50 and older. Employer contributions must make up the shortfall since only $20,500 may be contributed pretax from an employee's paycheck.

Although employer matching is a frequent strategy to assist workers get closer to their contribution limitations, creating a firm profit-sharing plan is the greatest way to fill up the whole 401(k) bucket — and profit-sharing advantages are available to both employers and employees.

Profit-sharing contributions' advantages

You, as the employer, must decide who is eligible for profit-sharing plan payments to retirement funds. For example, you may opt to concentrate your efforts on the leadership team.

When most profit-sharing systems are implemented, however, some money must be distributed to workers in addition to CEOs. We're not talking about a smidgeon here, but a substantial sum for individuals in your ranks.

The reason for this is because the Department of Labor conducts yearly testing.

Outside of the leadership team, profit-sharing payments must be proportionate to the amount granted to owners, executives, and managers. This is normally in addition to — not as a substitute for — any match or donation your corporation ordinarily makes.

As a result, a profit-sharing payment from your firm is a significant advantage to your employees, as well as a perk that may help you attract and retain personnel in a difficult labor market.

Profit-sharing has a lot of advantages for enterprises as well. Profit-sharing donations are tax-deductible, in addition to being a retention tool.

Contributions aren't subject to payroll taxes, so they may help you reduce your taxable income. That might add up to a lot of savings for your firm in a good year.

Profit-sharing plans also provide you the option of deciding how much to put into your workers' retirement accounts. For example, if the firm has a terrible year, you might contribute less, and vice versa.

Choosing the most appropriate profit-sharing plan for your employees

Despite the advantages, deciding whether or not to establish a profit-sharing scheme is a serious issue. Ask yourself the following questions before deciding on the scope and structure of your company's profit-sharing plan:

1. What percentage of my cash flow will I use for profit-sharing?

Once you contribute to a profit-sharing plan, the money is no longer in your company's records. You will never be able to get a single $1 back.

As a result, time is crucial. Before the corporate tax filing deadline, you may make a contribution at any time. Following that, the monies will be assigned to the preceding plan year.

2. Should some workers get greater benefits than others?

Profit-sharing contributions provide a lot of flexibility, which is sometimes overlooked. Contributions may be tailored to meet specific performance objectives.

If workers go into the year knowing this, the financial incentive will definitely incentivise and inspire team members to perform better. You may also reward top achievers with additional perks.

This may also be used as a performance incentive for the next year, encouraging staff to keep up their exceptional work.

3. Will I give workers with more than the bare minimum of benefits?

In general, the minimal benefit is a reasonable contribution, and most organizations that provide profit-sharing payments to workers just provide the minimum amount needed by the Department of Labor. After all, it's on top of a typical 401(k) account contribution.

Remember that you are paid in the same way as your workers, so you must decide whether to contribute the maximum amount to your retirement plan. Do you and the other executives aim to get the most out of the year?

Will this ruling have an effect on profit-sharing arrangements for employees?

Making a decision to contribute to a profit-sharing plan is a major step, but it may set your company apart from the competition. Employee profit-sharing schemes are rare in the business world.

Make a big deal out of the perk and explain that it's a way of showing your appreciation for the workers' hard work throughout the year. The gesture will be remembered and may help enhance your retention efforts for years to come.

Thanks to Matt Baisden at Business 2 Community whose reporting provided the original basis for this story.

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