What is a profit-sharing plan?

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A profit-sharing plan is a retirement plan that allows an employer or company owner to share the profits in the business, up to 25 percent of the company’s payroll, with the firm’s employees. The employer can decide how much to set aside each year, and any size employer can use the plan.

The benefit to employees is that they could accumulate more than in a typical 401(k) plan. And for 2020 workers can receive up to a whopping $57,000 total or 100 percent of compensation, whichever is less, in employer-sponsored accounts. A $6,500 catch-up contribution may also be made by those aged 50 or over in that tax year.

Here’s how a profit-sharing plan works, a comparison of the different kinds of plans available and the benefits of using these plans to reward employees.

How a profit-sharing plan works

A profit-sharing plan is one of many different kinds of retirement plans offering employers a way to provide a benefit to employees. The plan can provide a lot of flexibility in how money can be distributed, though employers must abide by certain rules in how they administer the plan, in order to avoid discrimination. Usually only employers contribute to a profit-sharing plan.

For employees, that means they need to do nothing to participate in the plan or max out its benefits. The profit-sharing is, in effect, a bonus on top of any other retirement benefits.

The plan can be operated as a separate account or it can be a feature added to a 401(k) account, but either way it’s only the employer making contributions through the profit-sharing feature.

As a qualified retirement plan, the funds can be withdrawn without penalty after the employee turns age 59 1/2, though withdrawals before that age are subject to a 10 percent penalty on top of any taxes owed. Withdrawal rules are similar to those for a traditional IRA, and participants will have required minimum withdrawals when they reach age 72.

From sole proprietors to large corporations, a company of any size can participate in the plan. Employers may decide how much to share with employees, up to 25 percent of their payroll during that tax year. The maximum amount of salary that can be used to figure the profit-sharing bonus is limited to $285,000 in 2020.

Employers are not obligated to use the program from year to year, allowing them to shut off the plan, if needed or desired. However, when the employer does make contributions, they must be made according to a predetermined formula, to ensure that the profits are divided legally.

Employers have flexibility in how benefits are distributed. Plans are tested annually to ensure that benefits are not being offered in a way that discriminates against employees, such as lower-level workers vis-a-vis managers and owners.

Like some other retirement plans, employers can require the funds to vest, meaning that employees must continue working at the company for a period of time before fully owning the funds. But once the employee owns the funds, they cannot be clawed back by the employer.

Types of profit-sharing plans

Profit-sharing plans come in a few varieties, but they’re all still fundamentally based on the employer providing money to the employee. The differences in these varieties involve how benefits are shared with employees, and the distribution schemes include:

  • Pro-rata plan – In this setup, everyone involved in the plan receives the same contribution from the employer. This could be a fixed dollar amount or percentage of salary.
  • Age-weighted plan – Under this plan, employers can consider how the profit-sharing would affect the employee’s retirement, taking age and salary into consideration. The net effect is that employers can offer older workers a higher percentage contribution than younger workers, because they have fewer years to retirement.
  • New comparability plan – In this plan, also called a cross-testing plan, the employer can contribute to different employee groups at different rates. This plan helps the employer reward different employee groups (including an owner) with various benefits, even if they have similar ages.

A pro-rata plan is the most standard choice, though it may be too rigid for many employers. The head of the company may receive 15 or 20 percent of compensation as part of the plan, meaning the lower-paid administrative staff receives the same percentage.

“As a pure employee benefit, this works great, but most employers are not looking to give to everyone at the same levels,” says Mark Wilson, president of MILE Wealth Management in Irvine, California.

And that’s where the other plan types come in. An age-weighted plan allows the employer to provide higher benefits to older employees and to do so legally, within certain limits.

The new comparability plan offers a lot of flexibility for employers or owners who want to retain the most for themselves even while offering employees a benefit. It also gives them a way to contribute to employees at various rates based on criteria that are important to the employer.

“For employers, they need to be strategic about the levels of employees they determine for their plan,” says Tatiana Tsoir, CEO of Linza Advisors in Mount Kisco, New York. Employers are able to favor “highly compensated employees by setting them up in a different group,” says Tsoir.

That flexibility offers employers the opportunity to fine-tune their benefits.

“For example, a new comp plan might give 10 percent to the legal staff and 5 percent to the administrative staff,” says Wilson. “In the right circumstances, these plans can work out very well.”

Such new comparability plans are limited in the differential they can offer employees, however. They must offer all employees at least either 5 percent of pay or one-third of what the most highly compensated employee receives under the plan.

Benefits of using a profit-sharing plan

For employees, the benefit is obvious – it allows them to save more. But these profit-sharing payments aren’t subject to Social Security and Medicare taxes, so the net benefits are even larger to employees than a comparable taxable bonus. A profit-sharing plan may offer quite a few benefits to employers, too, especially relative to other retirement plans.

First, a profit-sharing plan may motivate employees to be more productive. If they understand that their work translates into a higher reward, they may think more like owners of the business.

It may also help attract and retain skilled employees, and the adept use of a vesting schedule may help encourage the talent to stick around longer.

Employers also derive tax benefits from the profit-sharing plan. Contributions to a 401(k) with profit sharing are tax deductible, reducing the employer’s tax liability. Tsoir says that employers can decide as late as September of the next year and still get a deduction for the prior tax year.

While profit-sharing plans do require some annual testing and reporting requirements, they also “allow for vesting schedules, loan provisions, and different eligibility rules that are often better than plans like a SEP IRA,” says Wilson.

A SEP IRA, another popular retirement plan option among smaller businesses, may be easier to set up and administer, but it requires the business to pay the same retirement benefit to all employees, offering little flexibility. It also lacks the ability to require vesting, a feature that may help employees stick around longer.

Similarly, a SIMPLE IRA offers an easier way to set up a retirement plan with reduced reporting requirements. It too offers less flexibility in employer contributions and does not offer vesting.

So a profit-sharing plan can offer some notable advantages over other plans, and it can be set up as an add-on to a 401(k), making that plan the key hub for an employee’s retirement savings.

Bottom line

A profit-sharing plan offers employers a lot of flexibility when they decide to offer this benefit to employees, unlike some other retirement plans. Not only can employers turn off the benefit, if they need or want to, but they’re also able to more finely tune the benefits structure to reward certain employees more, even while taking a tax break for providing the benefits.

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