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Profit-Sharing 401(k)

When choosing the best retirement plan for their staff, companies often decide to offer a profit-sharing 401(k) plan. This is an excellent opportunity for both employers and employees as it combines the benefits of two different types of advantages at the same time. 

On the one hand, a 401(k) plan enables employees to save up for retirement by putting away a pre-tax sum of their salary. They get to choose how much to invest. In some cases, employers may match a part or all the employee’s investment. 

On the other hand, a profit-sharing plan allows companies to make discretionary employer contributions. It is up to businesses to decide how much to contribute. But in any case, employees enjoy the benefit since it increases their retirement savings.  

So, companies that want to promote their employees’ financial security in retirement often decide to merge profit-sharing with 401(k) and reap the benefits of both plans. 

What is a Profit-sharing 401(k)?

A 401(k) profit-sharing plan allows employers to contribute to a 401(k) employee plan every year. The employer decides how much money to put in, if any, usually depending on the company’s profitability. However, there is a profit-sharing 401(k) limit that companies must uphold. To find out more about the limits, check out the profit-sharing rules below. 

There are several ways for businesses to distribute 401(k) profit-sharing. 

  • Flat dollar amount: Employers put the same amount into every worker’s account. For example, each worker gets $2,000. 
  • Pro-rata plan: Each employee receives the same rate based on their salary. For instance, every employee receives a contribution of 3% of their salary. 
  • Age-weighted plan: Profit contribution rates correspond to workers’ retirement age. In other words, the older the employee – the higher the amount.  
  • New comparability: Companies group participants into different classes according to their preferences to allocate contributions. 

Profit-Sharing vs. 401(k)

A few key differences and similarities between profit-sharing and 401(k) plans.  

Both plans have the same purpose – helping employees save for retirement. In addition, they both allow for pre-tax contributions, and each plan must follow contribution limits. 

The main difference between a profit-sharing plan and 401(k) is in the plan contributors. Namely, only employers can put in funds towards profit-sharing plans, whereas contributions towards a 401(k) plan primarily come from an employee salary deferral.

Moreover, contributions by employees are entirely vested in a 401(k), but profit-sharing plans might impose vesting requirements. The vesting might be set at different rates according to the years of service or require a specific length of employment to reach 100% ownership

Who Can Offer a Profit-Sharing Plan?

Businesses of any size

Nonprofit or for-profit organizations

Companies that already offer other retirement plans

Businesses that are profitable or non-profitable[VB1] 


Who Can Participate in a Profit-Sharing Plan?

Every employee can participate, but there are eligibility requirements. Accordingly, a worker:

Must be at least 21 years of age or older

Must have at least one year of service

Should work 1,000 hours or more yearly

Cannot be a resident alien

Hasn't bargained in good faith for pension benefits 


Benefits of a Profit-Sharing Plan

A well-designed profit-sharing plan can be a As is evident, this plan can be beneficial in different aspects for both parties included.

Benefits for employers

Benefits for employees

It helps attract new talents and retain employees

Employees get a sense of ownership in the company

Employers can offer it along with other retirement plans

It provides an incentive to work harder

Contributions are tax-deductible

The amount of retirement savings is higher than without it

The amount of the contributions is flexible

It can enhance co-working and create a stronger team spirit[TM1] 

There are no extra costs when offering a 401(k) with a profit-sharing feature

It offers motivation to stay loyal to a company


Cons of a Profit-Sharing Plan

While, for the most part, a profit-sharing plan acts as a great incentive tool, that might not always be the case.

In fact, it can lead to dissatisfaction among employees. This usually happens as a result of the company culture. If an employer treats its employees with equality and respect, a positive working atmosphere is inevitable. However, suppose the staff feels the company behaves unjustly towards them. In that case, they may develop a negative perception and lack the motivation to cooperate with coworkers.

So, depending on how the profits are shared, some may deem it unfair if everyone gets the same amount or if the distribution has no affiliation to performance.

However, if it is solely based on performance, employees might focus on quantity rather than the quality of their work.

On the other hand, if the company distributes contributions depending on workers’ ranks, entry-level employees might never feel motivated to improve their performance or productivity.

Consequently, this plan is subject to annual nondiscrimination tests, which certify that contributions are proportional among rank-and-file employees, owners, and managers.

Profit-sharing Rules

Profit-sharing plans impose rules for employers and employees. There are limitations on maximum contributions, tax deductions, and reporting for employers. In contrast, employees need to consider the specific rules for using or withdrawing funds from this plan.

For employers

Contributions cannot be more than 100% of an employee's salary or $61,000 for 2022, whichever is lower.

The maximum compensation available for use per employee is $290,000 in 2022.

Employers can deduct a profit-sharing contribution from their taxes up to the contribution limit.

Cannot be a resident alien

Employers' deductions for contributions cannot exceed 25% of total annual employee earnings. 

Employees and all participants must receive participant disclosures. 

The company must fill out Form 5500 annually. 


For employees

Unlike rules for cashing out 401k, which the IRS sets, the employer determines rules for profit-sharing plans, thus making them more flexible.

Employees must pay a 10% early withdrawal penalty if withdrawing before age 59½ unless otherwise decided by the administrator.

Distributions entail taxes at ordinary income tax rates.

Depending on the employer, employees might take loans from the plan.

Employers' deductions for contributions cannot exceed 25% of total annual employee earnings. 

Employees can roll their vested contributions to an IRA plan.  


Types of Profit-Sharing Plans

Companies can decide to share their profits with the employees as bonuses, usually in cash, to stimulate productivity. At the same time, they can also defer them towards other benefits to secure loyalty. These options reflect the three types of profit-sharing plans.

  • Cash Plan
    Employees get compensation at the end of the quarter or of the year. Typically, they receive it in cash on their paycheck or as company stocks. The amount is tax-deductible for employers, but it is taxed as regular income for employees.

    With this plan, employees feel a sense of reward for their contribution to the company. It can result in increased motivation and productivity.
  • Deferred Plan
    Employers defer contributions, either in cash or stocks, towards an individual employee account. Generally, funds become available for retirement or in case of disability, death, or resignation. Since it is a way to add to employees’ retirement savings, it is often set up as a profit-sharing 401(k) plan. The contribution amount is not taxable until the employee receives it.

    By getting compensation at retirement, this plan promotes loyalty among workers. As a result, it enhances employee retention for the company.
  • Combination Plan
    As the name suggests, this plan combines both mentioned above. In other words, employees get annual cash or stock bonuses in addition to deferrals toward their retirement plan.

Establishing Profit-Sharing Plans

Before establishing a profit-sharing plan, companies need to decide how much and how to allocate the contributions. Once that decision is made, according to the Department of Labor, there are four steps a business should follow:

1. Creating a Written Plan

The plan must have a written document outlining the terms and day-to-day operations. The company can draft the document itself or get assistance from a financial institution or a professional. The plan document must include key functions such as:

  • The set formula for allocating contributions
  • The way of depositing the contributions
  • The vesting schedule
  • The method for determining eligible employees

2. Choosing a Trust for the Assets

The employer must hold the plan’s assets in a trust to ensure they are only there to benefit the participants and their beneficiaries. The trust must have at least one trustee who will manage contributions and investments and arrange distributions.

3. Establishing a Recordkeeping System

A recordkeeping system helps track and attribute contributions, distributions, earnings and losses, expenses, and plan investments. In addition, it provides support when preparing the plan’s annual Form 5500.

4. Delivering Plan Information to Eligible Employees

The company must notify eligible employees about the benefits, rights, and features of the plan. Moreover, each employee should receive a summary plan description (SPD). This is a brief explanation of the plan to inform workers of their rights and responsibilities. Usually, the SPD is created with the written plan document.

How Do Companies Benefit from Profit-Sharing Plans?

Profit-sharing plans promote a wide range of perks for companies and their workers.

One of the most significant advantages is that it is not a payroll item. If businesses want to reward their employees after a profitable year, profit-sharing plans allow them to do so without paying taxes.

Another great reason to have a profit-sharing plan is to attract and retain talent. Many employees consider retirement planning the most important benefit when looking for a job. This plan allows them to save even more for future days.

Moreover, sharing profits with workers gives them an incentive to work harder and achieve better results. Thus, it increases employee engagement and loyalty.

Terminating a Profit-Sharing Plan

In some cases, companies might decide to terminate their profit-sharing plan. Usually, this happens when they don’t want to offer a retirement plan anymore or if they are switching to a different one. Termination might also occur in the case of bankruptcy or a merger with another company. The steps for terminating a profit-sharing plan are:

  • Review the records and amend the written plan document
  • Establish a date of termination
  • Make final contributions to the plan
  • Distribute all available assets
  • Inform all employees of the termination
  • File a final Form 5500

However, employers should also check with a financial institution or a professional to see if there are any other necessary actions.

Conclusion

A well-developed 401(k) profit-sharing plan offers a retirement savings strategy that works for both companies and employees.

Employers enjoy a lot of flexibility by finely tuning the benefits structure. At the same time, employees gain by having larger retirement accounts.

However, creating a 401(k) profit-sharing plan requires a thoughtful approach and discussion. Companies have to be transparent about their profitability with their employees to make sure the contributions don’t fall short of expectations. In addition, workers have to understand how this plan works to get the most out of it.

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— Written by the<br> Shortlister Editorial Team

— Written by the
Shortlister Editorial Team

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