What Are Profit Sharing Plans?
Profit sharing plans are retirement plans in which employers share profits with employees through discretionary contributions based on earnings. 401(k)s are a type of profit sharing plan with capped employer contributions.
The advantages of profit sharing plans are tax deferrals and the fact that they can be used as incentives for better performance. The disadvantage of profit sharing plans is that they are discretionary, meaning employer contributions are not mandatory or guaranteed. The administration costs for a profit sharing plan are also higher than those for standard retirement plans.
Basics of Profit Sharing Plans
Profit sharing plans are also known as deferred profit sharing plans and are popular with small businesses and companies with few employees. The flexibility of such plans appeals to employers because they can manage cash flow based on their earnings for a given year. Unlike other retirement plans, which require mandatory annual contributions, a business owner can make no contributions to the plan one year and several thousands of dollars the next.
The maximum limit contribution for a profit sharing plan is capped at the lower of either $58,000 or 25% of an employee’s salary for 2021. The maximum contribution amount that can be considered for a profit sharing plan is $290,000 or 100 percent of an employee’s compensation, whichever is lower, for 2021.
Profit sharing plans are especially attractive to senior employees of a firm because they enable such employees to sock away more of their salary for retirement purposes. Those over the age of 50 can make up to $6,500 in catch up contributions to a profit-sharing plan, bringing the total amount for their annual contributions to $64,500.
Who Can Participate in a Profit Sharing Plan?
A profit sharing plan comes with strict non-discrimination clauses and, generally, employers offer profit sharing plans to all employees. However, companies can exclude employees from a profit sharing plan based on the following reasons:
- They are not 21-years-old.
- They have completed a minimum of a year in service.
- They are participants in a collective bargaining agreement that excludes profit sharing plans.
- They are certain nonresident aliens.
How Do Companies Calculate Share of Profits?
There are three ways in which companies calculate the profit figure to be shared with employees. The first method is to contribute a flat amount to each employee’s plan, regardless of position and seniority in tenure.
Suppose company ABC has ten employees and has a profit sharing pool (the percentage of its profits that it has set aside for a profit sharing plan) of $100,000 for a given year. It has decided to share 10% from the pool with each employee. Therefore, it will credit each employee’s profit sharing plan with $10,000. Therefore, Susan, who earns $75,000, receives $10,000 in her profit sharing plan account as does Mark, who earns $50,000.
The second method of calculating profit share is known as the comp-to-comp or pro rata method. In this method, companies share profits based on a percentage of the employee’s compensation. In the example above, let us assume that the combined compensation of all ABC employees is $500,000. Dividing the profits among employees means that each one is entitled to receive 20% ($100,000/$500,000) of their total salary. Therefore, Susan will receive $15,000 (20% of $75,000) as part of the plan and Mark will receive $10,000 (20% of $50,000).
The third method of calculating profit share is a new comparability profit sharing allocation. In this method, a gateway contribution, equal to a percentage of the employee’s compensation, is established for certain highly-compensated workers. Such workers are senior employees or owners. Next, a percentage contribution, regardless of seniority or position, for each employee is calculated. to ensure that all of them receive the same benefit amount when they retire.
In the example above, a gateway contribution, equal to 2% of her salary, is set aside for Susan because she is a senior employee. She is also allowed to put away a greater percentage of her salary as compared to Mark, who is a junior employee and does not have as many years of service as her. This is because Mark has more time to make contributions and reach Susan’s payout.
Advantages of Profit Sharing Plans
The advantages of profit sharing plans are as follows:
- They are more flexible as compared to traditional retirement plans because employers get to decide the terms and contribution limits for such plans.
- They provide tax deferral benefits to both employers and employees because all contributions are made pre-tax.
- It is easier for employers to manage their cash flows using profit sharing plans because they have the option to not make contributions based on the performance of their business.
- Profit sharing plans are excellent vehicles for senior employees and business owners to set aside more of their salary for retirement.
- They can be used as incentives for employees to work hard for the company’s success.
Disadvantages of Profit Sharing Plans
The disadvantages of profit sharing plans are as follows:
- They are more expensive to administer as compared to traditional profit sharing plans because they contain substantial non-discrimination clauses that must be tested each year.
- The discretionary nature of such plans means that employees are not guaranteed contributions each year.
- Profit sharing plans can end up benefiting senior employees and business owners more as compared to junior workers who may not be interested in long-term employment with a firm.