As a business owner or employee responsible for a company’s retirement offerings, you may be familiar with profit sharing plans. Also known as deferred profit-sharing plans, these defined contribution plans provide employees with a share of a company’s profits. The employer is responsible for determining how much and when the company contributes to the plan. Profit sharing plans can be a powerful tool to motivate employees to perform and compensate them for their hard work. Learn more about how profit sharing plans work and why you should speak with a retirement plans consultant.
Defining Profit Sharing Plans
If you have variable profits but still want to reward your employees by providing them with a percentage of the company’s profits, a profit-sharing retirement plan may be ideal for you. Profit sharing plans offer flexibility in how much a business owner wants to contribute each year. If desired, one or more years can be skipped. While profit sharing plans are best suited for self-employed individuals and small businesses that have up to 100 employees, nearly any business can benefit from this type of plan. There are also several significant perks that come with profit sharing, such as tax benefits.
Profit sharing acts as an incentive compensation program with amounts awarded to employees based on a company’s earnings each year or other set period of time. While profit sharing is similar to bonuses in which employees are rewarded money, profit sharing is only applied when a company earns a profit. These profits can be shared in the form of bonds and stocks or a cash amount. While there are both advantages and drawbacks to using a profit sharing plan, most companies find that such a program helps boost employee morale which can have a direct effect on your bottom line.
Defined Benefit Plans vs. Defined Contribution Plans
There are several distinct differences between a defined benefit plan and a defined contribution plan. More commonly known as a pension, a defined benefit plan is a type of retirement account in which an employer contributes funds to an account and promises to pay a set amount when an employee retire. In comparison, a defined contribution plan, such as a 401k or 403b, requires employees to contribute their own money. As defined benefit plans are more costly for employers, most companies have drastically reduced or completely eliminated defined benefit plans altogether.
Defined benefit plans generally come in two main varieties: cash-balance plans and traditional pensions. If an employee meets the basic eligibility requirements, he or she is automatically enrolled in either plan. However, to become fully “vested” in the plan an employee must remain at the job for a set period of time, usually five years. While there are similarities, the main difference is in how these benefits are calculated. In a cash-balance plan, an employee’s account is credited with a set percentage of his or her salary each year. With a pension, benefits are based on a formula that takes into account an employee’s average salary and amount of time at the job.
Managing a Profit Sharing Plan
Before setting up a profit sharing plan, you want to ensure that your company is indeed profitable and that you can expect to continue making sufficient money for a minimum of three years. A successful profit sharing plan will have clearly defined terms that cater to your company’s unique needs and goals. You will also want to continue fine tuning these terms. If you find that they do not work one year, make the necessary changes to ensure that they work the following year.
You will also need to determine a formula for allocating profits to employees. While many employers choose to make 10 to 15 percent of their pre-tax profits eligible for distribution, the decision is up to you. You will also want to consider the eligibility requirements for employees. Deferred plans usually require the eligibility of all employees. However, some profit sharing plans are only available to management level employees. Also decide how employees who may decide to leave the company before the allocation date will be paid or if they will receive payment at all.
Learn More About Profit Sharing Plans
Profit sharing plans are an innovative way to help employees save for retirement. While they are not right for all businesses, many companies find that setting up a profit sharing program can help attract and maintain talented employees. There are also certain benefits for business owners like the ability to avoid payroll taxes on profit sharing while also getting tax write-offs on contributions. However, like a 401k, companies must adhere to certain rules and regulations when managing a profit sharing plan. To learn more about profit sharing plans and if it is right for your company, contact a retirement plans consultant today.