Profit-Sharing Plans Explained

A profit-sharing plan is a retirement plan where employers share their business profits with their employees. This plan provides greater benefits to employees than the typical 401(k). And as of recently, employees who worked in 2022 can receive up to $61,000 or 100 percent of compensation, whichever is less. 

With a bounty of information on a subject like this, it can get a bit overwhelming to fully understand. So, here’s some information to ease your decision-making process.

What You Need To Know

A profit-sharing plan offers employers a way to provide benefits to their employees. The plan can be flexible in how money is allocated, but employers must continue to follow rules in how they administer the plan, to avoid discrimination.

Employers are the sole contributor to a profit-sharing plan. In other words, employees can accept the benefits of the plan without doing much work on their end. Making the plan incredibly convenient for most employees. 

The plan can be in combination with a 401(k), but only as a feature. Additionally, if needed, the plan can also function as a separate account. From large corporations to sole proprietors, any company of any size can partake in a profit-sharing plan. 

Employers have no obligations to use the program from year to year. This means that companies can determine when they want to keep the plan running or when they want to shut it off.

Likewise, when an employer makes contributions to the plan, they must follow a predetermined formula. This formula ensures that all profits are shared equally and legally. With this plan, employers are not allowed to discriminate against employees, like lower-level workers versus managers and operators.

Types Of Profit-Sharing Plans

There are several types of profit-sharing plans. The difference is centered around how benefits are distributed to employees.

Pro-rata plan – This plan secures that everyone involved gets the same amount of money from the employer. The distribution could be a percentage of the employee’s salary or a fixed dollar amount.

Age-weighted plan – In this specific plan, employers choose to consider how profit-sharing could affect the employee’s retirement. Essentially, considering the age and salary of the employee. This means that employers can legally, within certain limits, provide higher contributions to older employees.

New comparability plan – With this method of distribution, the employer can choose to pay employee groups at different rates. If employers or owners want to sustain most of the contributions for themselves, they can do so with this plan.

What Benefits Does A Profit-Sharing Plan Provide?

In terms of employees, the profit-sharing plan permits greater savings. Moreover, plan payments are not taxed by Social Security and Medicare. This means earned benefits are better for employees than a proportionate taxable bonus. A profit-sharing plan may also offer some benefits to employers as well.

Incentives For Productivity

Something like a profit-sharing plan will provide an incentive, motivating employees to be more productive and in turn, more profitable. If it is known that quality work equates to a higher reward, they’ll think of the business more like owners and less like employees.

It can also be a method to retain experienced employees, and with an added vesting schedule, can help in reducing the company’s turnover rates.

Tax Advantages

Employers will also receive tax benefits from a profit-sharing plan. Any contributions made to a 401(k) involved with profit sharing are tax deductible, which may curtail an employer’s tax liability. 

And when comparing other viable retirement plan options, it’s clear that a profit-sharing plan can be of benefit to many employers.  SEP IRAs, a retirement plan popular among smaller businesses, may be simple to get started and to set up and carry out, but it has no wiggle room. SEP IRAs require businesses to pay the same retirement benefit to all their employees, with little to no flexibility. 

Profit-sharing plans offer key advantages over other well-known retirement plans. Employees also have the ease of adding on to a 401(k), granting savers peace of mind when building up their retirement savings.

Bottom Line

So, this is how profit-sharing plans work and how they can be used as an incentive to gain long-lasting employees. With a plan like this, employers can choose when to provide these benefits and structure the benefit contributions how they see fit.