Are You Maximizing the Power of Profit-sharing?

Apr 25, 2022

What is Profit-sharing?

Profit-sharing is a type of defined contribution retirement plan that allows employers to share a pre-tax percentage of their company’s profits with employees. They are popular with business owners because of their flexibility. The contributions are tax-deductible for the previous tax year and give employers the opportunity to evaluate their finances before deciding on contribution amounts.

For instance, a company can change its’ contribution on a year-by-year basis depending on revenue. Even if there is no profit, a profit-sharing contribution can still be made. There are no set amounts that the law requires for the contributions, as long as they are recurring. For many companies, profit-sharing can be a powerful tool to motivate employees and align their financial health with that of the business.

Profit-sharing Plan vs. Traditional 401(k) Plan

A traditional 401(k) is not required to set up a Profit-sharing plan, but they can certainly be used together. There are two ways you can implement this.

Stand-alone profit-sharing plan (independent): With an independent profit-sharing plan, only employer contributions are allowed to be made. In other words, employees cannot contribute to this account with their salary. Small businesses may benefit from starting with an independent profit-sharing plan if they are still in a stage that has limited resources and revenue. It also avoids administrative costs and work required in maintaining a 401(k) plan, but still allows them to set one up in the future.
Combined 401(k) plan with profit-sharing: In this case, profit-sharing can be added to your 401(k) plan design as a separate plan feature. Both employers and employees can make contributions, combining the benefits of both into one retirement plan. More cost-efficiencies, increased tax deductions, and an alternative way to drive employee motivation are just a few of the perks.

Complimentary 401(k) Benchmark

Benefits of Profit-sharing

Attract and retain high-quality employees
Lower tax liabilities and increased tax deductions
Save more for employees’ retirement and ensure their financial future
Can help attract and keep talented employees
Benefit rank-and-file employees and owners/managers
May allow participants to take their benefits with them when they leave the company

Types of Profit-sharing

Determining which type of profit-sharing formula is right for your company is a crucial part of the design process. This choice will determine how and when to allocate profits to employees, as well as who is eligible. There are many different types of profit-sharing formulas.

Comp-to-comp (Pro-rata)

Comp-to-comp, also known as Pro-rata, is the most simple of profit-sharing plan types. All eligible employees included in the plan receive contributions at the same rate. It works similar to an employer match feature, in that everyone receives the same percentage.

Age-weighted

With an age-weighted plan, contribution amounts depend on the age of plan participants and their compensation. For this reason, an older employee who is closer to retirement age would receive a larger contribution than someone much younger. This can be beneficial for employers who want to reward long-time employees or give incentives to younger, valuable employees.

New Comparability (Cross-testing)

A new comparability profit-sharing plan, also known as cross-testing, is the most flexible option for business owners. All plan participants are grouped into categories that can have unique contribution formulas. Essentially, you can judge employees individually and customize the profit-sharing contribution for each. Creating separate benefit groups lets you allocate your profit exactly how you see fit.