A profit-sharing plan is a type of retirement plan that companies of all sizes can offer to their employees. These plans allow companies to pass along some of their profits to employees in a tax-advantaged way. They come with plenty of benefits for both employers and employees, including helping companies to attract skilled workers and helping employees to build their retirement nest eggs.
How Does Profit Sharing Work?
When a company offers a profit-sharing plan, it has decided to share its profits with employees in the form of retirement contributions. These contributions are discretionary, meaning employers can decide each year whether to make them.
In most cases, employers use a percentage-based method to decide how much to contribute to each employee’s plan. For example, suppose a small business had $100,000 in profit that it decided to share with its employees. Jan earns 10% of the company’s total wages, meaning she’ll get 10% — or $10,000 — of the profits shared. If Joe earns 5% of the company’s total wages, then he’ll get 5% — or $5,000 — of the total profits shared.
Because contributions in a profit-sharing plan are based on the company’s performance, they’re likely to vary from one year to the next. A company might contribute a large amount to each employees’ plan in a year when business is good, but half as much the next year of profits are lower.
A company might also decide to reduce contributions — or even pause them altogether — during a good business year. An example of when a company might do this is if they’re making capital improvements or investing in new infrastructure and need to keep more cash on hand.
Employers have a couple of different options for how to invest the money within a profit-sharing plan. First, they can allow employees to direct their own investments, in which case the employer would have to provide a select list of investment options for employees to choose from. On the other hand, employers can simply decide to manage the investments themselves rather than giving employees a say.
Once an employee is eligible to receive distributions from the profit-sharing plan, they can usually choose to receive a lump-sum distribution, roll the money over into an individual retirement account or another employer-sponsored retirement plan, or take periodic distributions during retirement.
Like other tax-advantaged retirement accounts, employees can begin taking distributions from a profit-sharing plan once they reach age 59½. Because the contributions are tax-free, plan participants will pay income taxes on their distributions.
Profit-Sharing Plan Requirements
Profit-sharing plans create a lot of flexibility for companies. That being said, there are still some requirements that both employers and employees should be aware of.
The profit-sharing plan should be available to both rank-and-file employees and owners/managers but may exclude employees who are:
- Under the age of 21
- Have less than one year of service
- Are covered by a collective bargaining agreement
- Are certain nonresident aliens
Each profit-sharing plan should have a set formula to decide how contributions will be allocated. Most commonly, companies allocate each employee a percentage of the profit that’s equal to their percentage of compensation. Contributions aren’t required but are limited to 25% of an employee’s compensation or $58,000 in 2021.
Companies can implement a vesting schedule before an employee can benefit from the plan, but it should be included in the plan document and apply equally to all employees.
Nondiscrimination: Companies with profit-sharing plans are required to provide benefits to both rank-and-file employees and owners/managers, and will be subject to annual testing to ensure this is the case.
When operating a profit-sharing plan, employers have a fiduciary duty to their employees, regardless of whether they manage the plan themselves or hire someone else to manage it. As a result, the employer and the individual managing the plan must act solely in the best interest of the plan participants, abide by the plan documents, and act with care, prudence, skills, and diligence.
Employers are required to keep employees up-to-date about the profit-sharing plan, including alerting them to any changes in the plan and providing individual benefits statements so they can understand the benefits they’ve earned.
Companies that offer a profit-sharing plan have to file several different forms with the federal government. First, Form 5500 is filed annually with both the IRS and the U.S. Department of Labor to share information about the plan and its operation. Form 1099-R should be filed with the IRS to report on distributions from the plan. Finally, Form 8955-SA should be filed with the IRS to report the deferred vested benefits of separated plan participants.
Pros and Cons of a Profit-Sharing Plan
Profit-sharing plans have some key benefits for both employers and employees, but it’s also important to understand the downsides for each party.
Pros of a profit-sharing plan
- Profit-sharing plans provide flexibility for the employer since contributions are completely discretionary.
- Employees who are offered profit-sharing plans as a benefit have the opportunity to grow larger retirement savings without any contributions on their part.
- Companies that offer profit-sharing plans may have an easier time attracting and retaining talented employees.
- Like some other tax-advantaged retirement plans, employees don’t have to pay taxes on the funds in their profit-sharing plans until they take distributions during retirement.
Cons of a profit-sharing plan
- Profit-sharing plans require administrative costs that may be higher than some other retirement plans like SIMPLE IRAs.
- Employees can’t contribute to profit-sharing plans, which gives them less control over their own retirement savings, especially if the company doesn’t also offer a 401k plan.
- Employers that offer profit-sharing plans are subject to nondiscrimination testing to ensure they benefit all employees, not just owners and managers. While this is advantageous for employees, it may be problematic for companies that wish to offer greater benefits to highly compensated employees.
How Is a Profit-Sharing Plan Different Than a 401k?
A 401k plan is another type of retirement plan that many companies offer their employees to help them save for retirement. The key difference between a profit-sharing plan and a 401k plan comes down to who makes the contributions and what they are based on.
In the case of a profit-sharing plan, the company contributes a percentage of its profits to its employees’ plans. Contributions are entirely discretionary, meaning there’s no requirement that companies make them each year, and can choose to do so only when the company is doing well. Additionally, it’s only the employer who contributes to the plan — employees don’t contribute.
A 401k plan, on the other hand, is primarily designed as a retirement savings tool for the employee. They can choose to contribute a percentage of their salary each year up to $19,500 per person. The money that employees contribute belongs to them, and they can decide to move it to an individual retirement account or a different 401k plan when they leave the company.
In addition to employees’ contributions, employers may also contribute to their workers’ 401k plans. Companies that do this usually agree to match their employees’ contributions up to a certain percent. For example, an employer might agree to match 100% of its employees’ 401k contributions, up to 3% of their salary. Or they might agree to match 50% of employees’ contributions up to 6% of their salary.
The good news is that you don’t necessarily have to choose between a profit-sharing plan and a 401k. Companies may choose to offer both. For example, an employer might offer a 401k plan with guaranteed contributions up to a particular percent of each employee’s salary. Then, the employer could also choose to establish a profit-sharing plan to further reward employees for the company’s success.
Establishing and Operating a Profit-Sharing Plan
If you’re a business owner, you might decide to establish a profit-sharing plan to give your employees a sense of ownership in the company and to give you more flexibility when it comes to contributing to your employees’ retirement plans.
Here are the steps to follow to establish and operate a profit-sharing plan in your business:
Step 1: Consult a financial institution or professional
The first step in creating your company’s profit-sharing plan is to consult a financial institution or professional. This person or entity can help you establish the plan in the first plan, as well as help you to maintain it moving forward.
Step 2: Create a written plan document
Each profit-sharing plan is bound by a plan document. Because that document will govern your plan, it’s important to have it in place from the beginning. If you’ve hired a company or individual to establish your profit-sharing plan, they will likely create your plan document for you. Otherwise, you can prepare the document yourself.
Step 3: Set up a trust for the plan’s assets
When you contribute funds to a profit-sharing plan, those funds must go into a trust to ensure they go to the plan beneficiaries, as promised. You’ll have to choose a trustee who will oversee the plan contributions, investments, and distributions.
Step 4: Create a system of keeping records
It’s critical that you keep thorough and accurate records for your company’s profit-sharing plan. Your recordkeeping should track your plan’s contributions, earnings, losses, expenses, investments, and distributions. Your recordkeeping system will also be important in compiling the records required for your plan’s annual report that you’ll have to file with the federal government.
Step 5: Share plan information with employees
Once your profit-sharing plan is set up, you’re required to notify eligible employees about it. You should create a summary plan description to let employees know about the plan, how it operates, and their benefits and rights under the plan.
Step 6: Decide who will manage the plan
Depending on your situation and the size of the company, you may decide to either manage the profit-sharing plan yourself or hire an individual or company to manage it for you. You may choose to have the company or professional who set up your plan continue to manage it. In that case, they will handle much of the administrative and recordkeeping work and ensure that your plan operates in accordance with your written plan document.
Step 7: Terminating a profit-sharing plan (optional)
In general, companies that establish profit-sharing plans should do so with the intention of operating them indefinitely. However, circumstances can change and you may eventually decide that a profit-sharing plan isn’t the right fit or that you simply want to switch to a different type of retirement plan.
To terminate a profit-sharing plan, you generally must amend the plan document, notify your employees about the termination, distribute the assets in the plan, and file a final Form 5500 to notify the federal government of the termination.
The Bottom Line
Profit-sharing plans provide an excellent opportunity for employers to help their employees build wealth and save for retirement in a flexible way.
These plans are beneficial to both employers, who can attract and retain talented employees, and to employees, who can build their retirement savings and be rewarded for their hard work. A profit-sharing plan is just one of the many types of retirement plans available to workers, but can be a great tool to add to any company or individual’s retirement toolbox.
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Personal Capital compensates Erin Gobler (“Author”) for providing the content contained in this blog post. Compensation not to exceed $500. Author is not a client of Personal Capital Advisors Corporation. The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.