When it comes to saving for retirement, both employees and employers are likely to be familiar with 401(k) plans. However, profit sharing plans are another approach to building retirement savings. While both 401(k) and profit sharing plans are tax-advantaged retirement options, there are important differences between the two. In fact, depending upon the nature of your business and your motivations for offering a retirement plan, you may find a profit sharing plan to be a great fit.
Who contributes to profit sharing plans?
One of the greatest differences between profit sharing and 401(k) plans is that with a straight profit sharing plan, only the employer contributes makes contributions, while employees make contributions to a 401(k) plan—with the employer having the option to add to these tax deferred savings. For example, while an employer may decide to match a portion of each employee’s 401(k) contribution, the employer is responsible for the entire contribution to each employee’s profit sharing account.
It is important to understand that “profit sharing” contributions do not necessarily reflect a particular share of company profits. Contributions can be made regardless of profitability. And the dollar amount contributed to any individual employee’s retirement savings is typically defined as a percentage of the employee’s salary, not a percentage of the company’s profits.
Here’s how a typical allocation might work: If Dan in accounting earned a salary of $50,000, and profit sharing contributions are made at 10% of salary, Dan would see a nifty $5,000 placed into his tax deferred retirement account.
Profit sharing plans allow for flexibility when making contributions
But what if cash flow is tight the following year? Management might determine that contributions should be reduced to 5% of salary, or even omitted for a year. That’s perfectly normal, and Dan may have seen this coming. After all he is in accounting. Besides, a profit sharing plan’s annual contributions reflect the company’s progress over the year. That’s one reason some employee’s find these types of retirement plans so attractive—they see a direct relationship between their own value added and their compensation.
Compare the above scenario to a typical 401(k) match. Say a company has decided to make a 100% match of every dollar employees contribute to their 401(k), up to 6% of their salaries. There is nothing to prevent an employer from dropping or eliminating the match in a particular year. But reducing the 401(k) match may take a bite out of morale. Employees may view 401(k) matching as company policy rather than a reflection of the company’s success. In fact, employees are often eager to step up their 401(k) contributions in anticipation of a company match. A reduced match may be seen as a reduced commitment toward employees.
Are all employees required to get profit sharing contributions?
Under the most basic types of profit sharing, when a company decides to make a profit sharing contribution, every employee receives it—except of course ineligible workers, like those under 18, or the very recently employed. However, an experienced retirement plan advisor can help you set up a “New Comparability” profit sharing plan – that may NOT require an employer to make contributions to every employee, or that helps you make the majority of the contributions to particular employees that you choose.
Traditional and New Comparability Contribution Options
A key difference between profit sharing and 401(k) plans is the flexibility that profit sharing plans have in allocating company contributions. (Read about some of the important the differences between a profit sharing plan and a 401(k) with a match here). For example, some may be structured to contribute an amount equal to 6% of each employee’s salary. But this approach is only one option.
At ForUsAll, we usually recommend that our 401(k) plans include a profit sharing feature allocating employer contributions using “New Comparability.” This structure offers considerable flexibility by allowing employers to direct more contributions to favored employees. For example, you might want to provide higher awards to more tenured or older employees, or those with a specific job function. Greater control over contributions also allows owners to contribute relatively more company funds to their own retirement and more to specific employees, like valuable salespeople or other executives. The maximum contribution per employee still holds, however.
The new comparability approach also allows employers to vary the dollar amount a company awards from year to year. This means companies can increase allocations in good years and pare back when business is on the lean side.
It is important to note that the way profit sharing plans divvy up contributions must be spelled out in a plan document. Creating this formula is just one of the many responsibilities involved in setting up and administering a retirement plan of this type. Other duties include notifying employees of the plan, recordkeeping, arranging a trust for the plan assets, and determining what assets are available as investment options.
If you are busy running your business you may want some help administering your retirement plan. You may even need help deciding if a more advanced retirement plan is right for your business, or if a traditional 401(k) is the better option.
A way to steer more company dollars to you and your employees
Whether you and your employees participate in a profit sharing or a 401(k) plan with a profit sharing feature, the maximum amount that can be added to an employee’s account in a single year is the same: $54,000. Reaching this maximum in a 401(k) plan with a profit sharing feature, would mean the employer contribution would be limited to $54,000 minus the employee contribution, which could be as much as $18,000..
But to the reach that same maximum in a straight profit sharing plan, the company would contribute the entire $54,000.
As you can see, with a well structured plan, the employer can direct more company dollars toward her own retirement and that of her employees. And because those company contributions are tax deductible, there is a larger potential for tax savings with a profit sharing plan, all things equal.
This type of a retirement plan approach may or not be ideal for your business. You may prefer the 401(k) structure where employees fund a significant share of their own tax deferred savings. For example, if much of your cash flow is being reinvested into the company, it may be unreasonable to anticipate making significant profit sharing contributions. In that case, a traditional 401(k) with an added profit sharing feature may be the preferred approach to attracting and retaining great employees.