Share the Wealth: Everything you need to know about profit sharing 401(k) plans
In addition to bonuses, raises, and extra perks, many employers elect to add profit sharing to their 401(k) plan. Read on for answers to frequently asked questions.
Has your company had a successful year? A great way to motivate employees to keep up the good work is by sharing the wealth. In addition to bonuses, raises, and extra perks, many employers elect to add profit sharing to their 401(k) plan. Wondering if it might be right for your business? Read on for answers to frequently asked questions about profit sharing 401(k) plans.
What is profit sharing?
Let’s start with the basics. Profit sharing is a way for you to give extra money to your staff. While you could make direct payments to your employees, it’s very common to combine profit sharing with an employer-sponsored retirement plan. That way, you reward your employees—and help them save for a brighter future.
What is a profit sharing plan?
A profit sharing plan is a type of defined contribution plan that allows you to help your employees save for retirement. With this type of plan, you make “nonelective contributions” to your employees’ retirement accounts. This means that each year, you can decide how much cash (or company stock, if applicable) to contribute—or whether you want to contribute at all. It’s important to note that the name “profit sharing” comes from a time when these plans were actually tied to the company’s profits. Nowadays, companies have the freedom to contribute what they want, and they don’t have to tie their contributions to the company’s annual profit (or loss).
In a pure profit sharing plan, employees do not make their own contributions. However, most companies offer a profit sharing plan in conjunction with a 401(k) plan.
What is a profit sharing 401(k) plan?
A 401(k) with profit sharing enables both you and your employees to contribute to the plan. Here’s how it works:
- The 401(k) plan allows employees to make their own salary deferrals up to the IRS limit.
- The profit sharing component allows employers to contribute up to the IRS limit, noting that the maximum includes the employee's contributions as well.
- After the end of the year, employers can make their pre-tax profit sharing contribution, as a percentage of each employee’s salary or as a fixed dollar amount
- Employers determine employee eligibility, set the vesting schedule for the profit sharing contributions, and decide whether employees can select their own investments (or not)
What’s the difference between profit sharing and an employer match?
Profit sharing and employer matching contributions seem similar, but they’re actually quite different:
- Employer match—Employer contributions that are tied to employee savings up to a certain percentage of their salary (for example, 50 cents of every dollar saved up to 6% of pay)
- Profit sharing—An employer has the flexibility to choose how much money—if any at all—to contribute to employees’ accounts each year; the amount is not tied to how much employees save.
What kinds of profit sharing plans are there?
There are four main types of profit sharing plans:
- Pro-rata plan—Every plan participant receives employer contributions at the same rate. For example, every employee receives the equivalent of 5% of their salary or every employee receives a flat dollar amount such as $1,000. Why is it good? It’s simple and rewarding.
- New comparability profit sharing plan (otherwise known as “cross-tested plans”)—Employees are placed into separate benefit groups that receive different profit sharing amounts. For example, business owners (or other highly compensated employees) are in one group that receives the maximum contribution and all other employees are in another group and receive a lower amount. Why is it good? It offers older owners the most flexibility.
- Minimum Gateway – In order to utilize new comparability, the plan must satisfy the Minimum Gateway Contribution – All non-highly compensated employees (NHCEs) must receive an allocation that is no less than the lesser of 5% of the participant's gross compensation, or 1/3 of the highest contribution rate given to any highly compensated employees (HCEs).
- General Test – Once the minimum gateway is passed, it must pass the general test which breaks up the plan into “rate groups” based on their Equivalent benefit Accrual Rate (EBAR). Every HCE is in their separate rate group, which includes all participants who have an EBAR equal to or greater than that HCE.
- If the ratio percentage for each rate group is 70% or higher, the plan passes, and no further testing is necessary. If each rate group does not satisfy the ratio percentage test, then we revert to using the average benefits test.
- The average benefits test is the more complicated test, and consists of two parts: the nondiscriminatory classification test and the average benefits test. Betterment will always try to make the test pass using the ratio test method first.
- Permitted disparity—Employees are given a pro-rata base contribution on their entire compensation (up until the IRS limit). In addition, employees who earn more than the integration level, will receive an excess contribution on the amount over that limit. The integration level that provides the highest disparity allowed (5.7%) is the Social Security Taxable Wage Base (SSTWB). Plans that choose to lower the integration amount will receive a reduced disparity limit. Why is it good? It offers younger HCE’s who make more than the SSTWB a greater benefit.
- Age-weighted profit sharing plan—Employees are given profit sharing contributions based on their retirement age. That is, the older the employee, the higher the contribution. Why is it good? It can help with employee retention.
How do I figure out our company’s profit sharing contribution?
First, consider which type of profit sharing plan you’ll be using—pro-rata, new comparability, permitted disparity, or age-weighted. Next, take a look at your company’s profits, business outlook, and other financial factors. Keep in mind that:
- There is no set amount that you have to contribute
- You don’t need to make contributions
- Even though it’s called “profit sharing,” you don’t need to show profits on your books to make contributions
The IRS notes that the “comp-to-comp” or pro-rata method is one of the most common ways to determine each participant’s allocation. Using this method, you calculate the sum of all of your employees’ compensation (the “total comp”). To determine the profit sharing allocation, divide the profit sharing pool by the total comp. You then multiply this percentage by each employee’s salary. Here’s an example of how it works:
Your profit sharing pool is $15,000, and the combined compensation of your three eligible employees is $180,000. Therefore, each employee would receive a contribution equal to 8.3% of their salary.
|Employee||Salary||Calculation||Profit sharing contribution|
|Taylor||$40,000||$15,000 x 8.3%||$3,333|
|Robert||$60,000||$15,000 x 8.3%||$5,000|
|Lindsay||$80,000||$15,000 x 8.3%||$6,667|
What are the key benefits of profit sharing for employers?
It’s easy to see why profit sharing helps employees, but you may be wondering how it helps your small business. Consider these key benefits:
- Provide a valuable benefit (while controlling costs)—With employer matching contributions, your costs can dramatically rise if you onboard several new employees. However, with profit sharing, the amount you contribute is entirely up to you. Business is doing well? Contribute more to share the wealth. Business hits a rough spot? Contribute less (or even skip a year).
- Attract and retain top talent—Profit sharing is a generous perk when recruiting new employees. Plus, you can tweak your profit sharing rules to aid in retention. For example, some employers may elect to have a graded or cliff profit sharing contribution vesting schedule to motivate employees to continue working for their company.
- Rack up the tax deductions—Profit sharing contributions are tax deductible and not subject to payroll (e.g., FICA) taxes! So if you’re looking to lower your taxable income in a profitable year, your profit sharing plan can help you make the highest possible contribution (and get the highest possible tax write-off).
- Motivate employees to greater success—Employees who know they’ll receive financial rewards when their company does well are more likely to perform at a higher level. Companies may even link profit sharing to performance goals to motivate employees.
What are the rules?
The IRS clearly defines rules for contribution limits and calculation rules, tax deduction limits, deadlines, and disclosures (as with any type of 401(k) plan!). Be sure to keep an eye out for any annual changes from the IRS.
Are there any downsides to offering a profit sharing plan?
Contribution rate flexibility is one of the greatest benefits of a profit sharing 401(k) plan—but it could also be one of its greatest downsides. If business is down one year and employees get a lower profit sharing contribution than they expect, it could have a detrimental impact on morale. However, for many companies, the advantages of a profit sharing 401(k) plan outweigh this risk.
How do I set up a profit sharing 401(k) plan?
If you already have a 401(k) plan, it requires an amendment to your plan document. However, you’ll want to take the time to think through how your profit sharing plan supports your company’s goals. Betterment can help.
At Betterment, we’re here to help with a range of tasks from nondiscrimination testing to plan design consulting to ensure your profit sharing 401(k) plan is working the way your business needs. And as a 3(38) fiduciary, we take full responsibility for selecting and monitoring your investments so you can focus on running your business—not managing your retirement plan.
Ready for a better profit sharing 401(k) plan? Get started here.
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