If you're looking for a flexible way to reward your team and boost retirement benefits, a profit-sharing plan could be a smart addition to your business. Whether paired with a 401(k) or offered on its own, profit sharing allows employers to distribute a portion of company profits to employees on their own terms.
Let’s break down how profit-sharing plans work, how contributions are calculated, and what makes them a great fit for certain types of businesses.
What is Profit Sharing?
Profit sharing gives a company the ability to make additional discretionary contributions to employees’ 401(k) accounts above and beyond anything they’ve done in the way of an employer match or other 401(k) benefits.
Profit sharing can be rolled into a 401(k) plan or can be established as a separate plan. With a profit-sharing plan, a company distributes a portion of its pre-tax profits to its employees. These contributions are typically tax-deductible in amounts up to 25% of the company’s payroll.
Unlike a 401(k), which is funded via employee contributions and optional employer matching contributions, only the company can contribute to the profit-sharing plan, not employees.
Employers can choose from various types of profit-sharing plans. In our experience at FSRP, profit-sharing plans are usually built into existing 401(k) plans as a way to enhance the retirement plan. However, some companies offer a profit-sharing plan alone, without a 401(k).
How Does Profit Sharing Work?
Profit-sharing contributions are normally calculated and distributed after the calendar year closes, but before the accountant files taxes for the previous year. This allows the accountant to work with the employer to determine the actual profit the company made and how much they would like to share with employees, if any.
Profit sharing can be done quarterly or annually. Employees typically receive a percentage or a specific dollar amount of the company’s profits, which are deposited into their 401(k) or a separate profit-sharing account.
As with their 401(k), employees generally don’t pay taxes on these funds until they are distributed upon retirement.
So, how are profit-sharing contributions calculated?
The employer must decide which formula to use for profit allocation, which ensures that employees of all levels and compensation are awarded fairly. Don’t stress it—your financial advisor can help you determine which method would best suit your plan and business.
The comp-to-comp or pro-rata method is most common, which divides employer contributions based on each employee’s compensation relative to the total compensation of all eligible employees. This means employees with higher earnings receive a proportionally larger share of the profit-sharing contribution.
Let’s use an example of the comp-to-comp calculation, where the business allocates 10% of its $500,000 annual profit, resulting in a total of $50,000 to distribute. The company has three eligible employees with the following salaries:
- Employee A: $60,000
- Employee B: $90,000
- Employee C: $150,000
Each employee’s share of the $50,000 contribution is based on their portion of the total compensation:
- Employee A: ($60,000 / $300,000) × $50,000 = $10,000
- Employee B: ($90,000 / $300,000) × $50,000 = $15,000
- Employee C: ($150,000 / $300,000) × $50,000 = $25,000
Benefits of a Profit-Sharing Plan
In addition to supporting your employees, a profit-sharing plan can greatly benefit your company by:
- Helping recruit and retain employees: A profit-sharing plan is an additional benefit that attracts new talent in a competitive job market and fosters loyalty among your team. It will also allow up to a 6 year graded vesting schedule helping with employee retention efforts.
- Boosting employee motivation and productivity: Employees become more committed to the company’s success, which in turn encourages them to stay longer, as they feel valued and pivotal to the business's performance.
- Providing tax advantages for ownership and key employees: Employer profit-sharing contributions are generally tax-deductible, and contributions to employees are exempt from payroll taxes (i.e., Social Security or Medicare). Higher earners also enjoy tax-deferred growth, higher contribution limits than many other retirement options, and reduced current taxable income.
- Offering flexibility in contributions: A company can opt to offer profit-sharing contributions only in years they can afford it. This means you could offer contributions one year, skip a year, and then fund it the next.
- Supporting retirement readiness: By enhancing your employees’ retirement savings, you’ll reinforce a positive company culture and long-term employee well-being.
What Should Employers Consider?
While profit sharing can be an attractive retirement benefit, it may not be the right fit for all companies. It tends to work best within closely held companies that don’t have a large number of employees, thanks to their:
- Greater flexibility and control in determining annual contributions and allocations
- Lower administrative burden regarding compliance and testing requirements (e.g., nondiscrimination testing)
- Larger contributions and maximized tax efficiency for owners and key employees (within legal limits)
- Stronger link between effort and reward for employees
When contemplating a profit-sharing plan for your company, you’ll also want to consider factors such as:
- Cash flow consistency to ensure you have sufficient, reliable profits and cash flow to make meaningful contributions in profitable years
- Your employee demographics (i.e., age, compensation levels, and roles) and whether the plan will be seen as fair and motivating across your team
- Long-term business goals and how a profit-sharing plan fits into your broader compensation and retirement planning objectives
- The cost of contributions and administration against the value of improved employee engagement, retention, and tax advantages
- Administrative responsibilities, such as compliance with the IRS and Department of Labor, including nondiscrimination testing and plan filings
Is Profit Sharing the Right Fit for Your Company?
Bottom line: A profit-sharing plan is essentially driven by a company’s culture and its ability to fund it. Executed successfully, profit sharing can have a significant impact on morale and organizational goals—not to mention long-term growth for both the business and its workforce.
If you’re interested in learning more about how profit sharing works and if it would be ideal for your business, FSRP can help! Contact us today to discuss your options.
Securities and advisory services offered through Commonwealth Financial Network, Member FINRA/SIPC, a Registered Investment Adviser. Financial Strategies Retirement Partners (FSRP) is a Registered Investment Adviser. Financial planning services offered by FSRP are separate and unrelated to Commonwealth.