What’s the difference between a Profit Sharing Plan and 401(k) with an Employer Match?
Background: What is a profit sharing plan?
If you’re just starting your research into profit-sharing plans, it may appear that profit-sharing plans are much like a 401(k) plan with a match from an employer. Both involve employers giving employees a certain amount of money in a given year. These contributions are put into a tax-deferred account, which means both the employer contributions and the investment earnings an employee might make are tax-deferred until the employee starts withdrawing money from the account, usually after retirement.
Two differences between a 401(k) plan with an employer match and a profit sharing plan
A 401(k) plan with a match and a profit-sharing plan are both retirement plan options that provide an employee with a contribution from their employer – but they differ in two important ways.
- How they assign the criteria for who receives the employer contributions – With a 401(k) match, only employees that are eligible and participating in the 401(k), can benefit from the company match. With a profit sharing contribution – any eligible employee can receive the benefit.
- How much the employer can deduct on their taxes (between salary paid to the employee and employer contributions to the plan) — in 2017, the maximum deduction is up to $53,000 (or $59,000 for employees over 50 years old who are now eligible to make catch up contributions). Through matching only plans, the maximum total contribution to the plan is $36,000, while through profit sharing contributions, the maximums of $53,000 (or $59,000 if 50 or older) can be achieved.
Essentially, the profit-sharing plan puts the employer in control, and allows employers to determine key requirements for who’s eligible to receive the tax-deferred contributions.
And, while both 401(k) employer match and profit-sharing can be put on “pause” in any given year, the profit-sharing plan is modeled to incentivize employees to work harder during the year to boost the potential contribution amount the employee can receive. Why? Because profit-sharing contributions are typically tied to annual profits, while an employer match on the 401(k) is simply tied to each individual employee’s contribution.
Tying the employer contribution to a company’s profit is key as we go into the first critical difference between a 401(k) employer match and a profit-sharing plan.
Critical Difference #1: Assigning a criterium for which employees receive employer contributions.
While profit-sharing plans that give every employee a contribution do exist — similar to an employer 401(k) match, being able to tailor contribution amounts to specific employees is a differentiator with the profit-sharing plan.
By giving employers flexibility in designing key features, employers can now choose how much to contribute to the plan and which specific employees will receive the contributions. This opens the door for employers to:
- Use the profit-sharing plan to help attract and retain specific, key talent.
- Get all key employees motivated to contribute to the company’s bottom line, allowing employers to share profits amongst a mix of rank-and-file employees and owners/managers.
Critical Difference #2: Employers can deduct up to $53,000 from their annual business taxes.
Just like employer 401(k) matching contributions, profit-sharing contributions are also tax deductible for the business (and depending on how the business is organized, these deductions may flow right through to the owner’s personal return). But through the profit-sharing plan, employers can put up to $53,000 into each employee’s account and deduct those amounts from the company’s taxes — much higher than the $36,000 contribution limit solely through the 401(k). And this amount is higher for those over 50 years old using catch-up contributions, where the annual contribution limit for 2017 is $59,000.
However, one thing to look out for from the employer perspective is the additional maintenance and administrative work that goes into a profit-sharing plan versus a more simple retirement plan like a SEP or a SIMPLE IRA. In addition to the added administrative work, employers will need to keep a close eye on the annual IRS testing to ensure they aren’t in a position to fail the nondiscrimination tests. If you already have a retirement advisor, find out how much of the additional work they’ll take on if you wish to offer a profit-sharing plan. A few good questions to ask are:
- How do you run IRS non-discrimination testing? Is the analysis done monthly? Quarterly?
- How will you communicate with me the results of the test and how do you correct the plan and employee contributions before the end of the year?
- Are there additional fees that will be charged by offering a profit-sharing plan?
- Will you make a recommendation on the type of profit-sharing plan we should offer and will you make profit-sharing contribution calculations for me?
ForUsAll Preferred Profit Sharing Plan Design – New Comparability
ForUsAll’s standard profit sharing method is new comparability – which gives employers a lot of flexibility in how they award profit sharing allocations. With this type of plan, contributions are not allocated strictly as a percentage of compensation. This flexibility provides the ability to reward employees based on seniority, tenure, salary levels, function and more to encourage employee retention (and retirement success!). New comparability may also allow business owners to improve their own retirement situation by boosting tax-advantaged contributions to their own profit sharing accounts.
Another advantage to new comparability plans, and to the plan design ForUsAll generally recommends, is that companies can be flexible in the amount of profit sharing they offer any given year – and can choose the allocations at the end of the year. Therefore, an employer can make a decision on how generous to be, and can adjust downward the allocations in lean years and increase them in highly productive years.