Profit sharing plans can help provide financial security in retirement for employees while giving employers a motivational tool to attract new talent. Also referred to as a deferred profit sharing plan (DPSP), this plan involves giving employees a share in the profits of the company they work for. Under profit sharing plans, all contributions from employers are discretionary, meaning the company makes the decision of how much to contribute from year to year or whether to contribute anything at all. In general, if a company does not make a profit in a given year, it does not have to make a contribution to an employee’s plan.
Appeal of Profit Sharing
Profit sharing plans are a flexible tool that acts as a great retirement plan option for businesses of all sizes. By aligning the financial well-being of an employee to a company’s success, employees are motivated to work harder to ensure that a company earns measurable profits. Profit sharing plans are also an effective way for companies to give employees a sense of ownership within the business. Each year that a company chooses to make contributions, they must decide on a set formula for profit allocation.
How Profit Sharing Works
Unlike certain types of retirement plans like 401(k)’s, employees who participate in profit sharing plans do not make their own contributions. Employees can receive their profit shares in several ways, such as in the form of company stock or cash. Generally, all contributions from employers are transferred to a qualified tax-deferred retirement account that permits penalty-free distributions to be taken after age 59.5. In some instances, a profit sharing plan may combine cash with deferred benefits. In this case, the cash is distributed and taxed at regular income rates. If an employer chooses to leave the company, they have the option to move all assets from a profit sharing plan to an IRA.
Allocating Profit Shares
One of the most common ways for a company to determine how to allocate funds in a profit sharing plan is through the comp-to-comp method. This method first involves calculating the total sum of all employee compensation. To determine the percentage of a profit sharing plan an employee should receive, a company then divides each worker’s annual compensation by the total compensation. Companies of all sizes that choose to establish a profit sharing plan may also have other available retirement plans. They will also be responsible for filing Form 5500 annually.
Currently there is no set amount that must be contributed to a profit sharing plan annually. However, there is a maximum amount that can be contributed per employee. The maximum contribution amount is the lesser of 100 percent of compensation, or $54,000. However, the amount can fluctuate over time based on inflation. In addition, the amount of compensation that can be considered when determining both employer and employee contributions is limited. The current compensation limit is $270,000. Any early withdrawals from a profit sharing plan are subject to certain penalties, much like any other type of retirement plan.
Benefits of Profit Sharing
There are a number of advantages of profit sharing plans for both employers and employees. First, businesses of all sizes can set up profit sharing plans to motivate and retain talented employees. In addition to profit sharing plans, these companies can also choose to maintain other types of retirement plans, such as 401(k)’s. A profit sharing plan can be made as simple or as complex as a company desires. To make the process easier by reducing administrative work, companies can buy an established profit sharing plan document from a retirement plan benefits professional.
Many times, employers want to provide employees with extra compensation but do not have the funds to do so. If cash flow is an issue, profit sharing plans can be especially useful. As contributions are strictly discretionary, employers have the flexibility to allocate funds when profits allow. Employees can also benefit by gaining access to funds without any personal contributions. Profit sharing plans require contributions by employers only. When an income deferral feature is incorporated into a profit sharing plan, it is considered a 401(k) plan.
Learn More About Profit Sharing Plans
Profit sharing contributions are no doubt one of the most flexible types of employer contributions that a business can make towards retirement savings. As contributions are flexible, they can be an excellent choice for startup businesses or companies that have erratic profits. However, profit sharing plans are not right for everyone depending on the size of your business, your profitability, and similar factors. Before making a decision about whether or not profit sharing is right for you, speak with a wealth management consultant. Wealth management consultants can guide you in the right direction based on your unique circumstances to ensure that you make the right decision.