Profit-sharing plans: Retirement accounts that give employees a percentage of a company's profits

• Profit-sharing plans are tax-advantaged retirement plans offered by employers where they contribute to the account based on the profitability of the business.
• Employers that participate in a profit-sharing plan increase how much they're able to contribute to an employee's retirement while decreasing their tax liability.
• Employers can also pay themselves as a part owner of the company with profit-sharing plans.

A profit-sharing plan is an employer-sponsored retirement plan where the employer contributes pre-tax dollars to an employee's account based on the profitability of the company. The employer has full discretion at what percentage of the business' profits will be shared with employees of the organization as well as what employees are eligible to participate. The flexibility of a profit-sharing plan is also met with generous tax advantages which benefit both the employer and employee.

"This is a way to offer compensation that is not a full-blown contractual obligation, is flexible and is tax efficient, since it is deductible to the business, but not currently taxable to the employee," says Chester Spatt, professor of finance at Carnegie Mellon University's Tepper School of Business.

How do profit-sharing plans work?

Profit-sharing plans are set up by employers, usually as a feature of an employee's 401(k) account, though a profit-sharing plan can also be set up as a stand-alone account. Under a profit-sharing plan, employees are given a percentage of a company's profits based on earnings.

Employers will have a written plan document with a set formula (which we'll cover later) for how much of a company's profits will be distributed to participants. They must also arrange a trust for the plan's assets, develop a record-keeping system, and provide plan information to employees eligible to participate. .

Employers offer profit-sharing plans to help employees feel valued. "Profit sharing is a way of incentivizing employees to take actions that increase the company's profits so that they can earn more as well," said Shawn Plummer, CEO of The Annuity Expert. "It can also attract and retain talented employees who are skilled enough to help the company achieve its goals."

Employers can determine who's eligible to participate. Employers can also determine which employees are eligible to participate in a profit-sharing plan. Employers can exclude employees who are under the age of 21 or work less than 1,000 hours per year. Employers can also use a vesting schedule, which is a preset schedule that gives an employee ownership over a percentage of the funds in their account over time. A vesting schedule is a great way for employers to encourage and reward longer-term employees who stay at a company.

Employers follow a set formula for contributions. Employees do not contribute to profit-sharing plans - only employers do. In order to determine how much money goes into each account, employers will need to have a set formula for calculating how they will be divided. The simplest and most common is known as the comp-to-comp method, where contributions are based on the proportion of an employee's compensation to the total compensation of all employees of the organization. There's no required profit-sharing percentage, but experts recommend staying between 2.5% and 7.5%.

While the plan document has a set formula for contributions, employers have the flexibility to change the amount of contributions each year, or even forgo contributions altogether. This is an especially valuable aspect of profit-sharing plans for businesses that experience volatility throughout the year.

"Profit-sharing plans are especially useful to businesses that anticipate variability in their earnings [or] cash flow and desire flexibility in their commitments to contribute to a qualified plan," says Greenbeat Financial CFP Adam Scherer. "By implementing a profit-sharing plan, employees can participate in the overall success of the company, receiving additional compensation in profitable years. This arrangement supports long-term employee retention, drives work performance, and can serve to attract additional talent into the company."

Contribution limits of a profit-sharing plan

Contributions are limited to the lesser of 100% of an employee's salary or $58,000 for 2020. Since most employee contributions are capped at $19,500 for a 401(k), a profit-sharing plan gives employers a flexible option for increasing the amount contributed for an employee while decreasing their own tax liability.

For example, if an employer offers a 401(k) match up to the maximum amount, the employee has the potential to put away $39,000 per year ($19,500 employee + $19,500 employer). The business has room to contribute $19,000 more for the employee in pre-tax dollars to get to the $58,000 max allowed by the IRS by participating in a profit-sharing plan.

Tax advantages for a profit-sharing plan

Where a profit-sharing plan really shines is in the tax advantages. For small businesses, owners can put away more money for their own retirement by administering a profit-sharing plan for all employees. Employers are paid along with every other employee, and can max out the amount an employer is allowed to contribute to a retirement plan.

"Profit sharing allows for more money to be put away pre-tax," says Tatiana Tsoir, CPA and founder of Linza Advisors, shared with Business Insider in an email, "It's very attractive especially considering that most people get into a higher tax bracket in their earning years than after retirement. They end up paying less tax overall!"

Employers can take a deduction of 25% of the amount paid out to employees for the year, thereby decreasing the tax liability for the business. Funds grow tax free in the investment account until they are distributed. As with a 401(k), employees can withdraw funds at age 59 ½ without penalty. Funds withdrawn before this age incur a 10% penalty.

Requirements for profit-sharing plans

Businesses who want to administer a profit-sharing plan can be of any size. There are also no restrictions on businesses that are already administering other retirement plans.

Businesses need to follow nondiscrimination rules set by the IRS to be eligible for the tax benefits of a profit-sharing plan. Nondiscrimination rules require employers to provide substantive benefits for rank-and-file employees of the organization, not just highly-compensated employees. The profit-sharing plan is subject to annual testing to ensure benefits do not discriminate in favor of highly-compensated employees.

With a profit-sharing plan, businesses also have fiduciary responsibilities, even if the action is choosing whom to hire as a fiduciary for the plan. Some of the responsibilities of the fiduciary include:

• Acting on behalf of participants in the plan
• Following the plan document
• Carrying out duties with skill and prudence
• Diversifying the plan investments
• Making sure the contributions due the plan are collected

Businesses need to file Form 5500 with the IRS when administering a profit-sharing plan. This is an annual return and report of employee benefit plans where information about the operation of the plan is shared with the IRS and the US Department of Labor.

Pros and cons of profit-sharing plans

Profit-sharing plans can be beneficial to both employer and employees. However, because profit sharing is administered at the owner's discretion, employees have no control in contributing to this plan. A profit-sharing plan is usually an addition to a 401(k) plan, not a replacement.

Quick tip: Contributions and earnings from a profit-sharing plan grow tax free until they are distributed.

A profit-sharing plan can help an employer incentivize employees while also decreasing tax liability for the business.

Is a profit-sharing plan the same as a 401(k)?

A profit-sharing plan is not the same as a 401(k), but is often referred to as an add-on feature to a 401(k). An employee may or may not have two different accounts from an employer who administers a profit-sharing plan. Contributions grow in investments as they would in a 401(k).

A profit-sharing plan is different from a profit-sharing distribution (or bonus), which is given directly to the employee rather than deposited into a 401(k) retirement account. Often called a cash profit-sharing plan, these bonuses are taxed when distributed to the employee, whereas contributions to an employee's 401(k) or profit-sharing plan are not taxed until they are taken out in retirement.

A profit-sharing plan increases the maximum amount an employer can contribute to an employee. With a profit-sharing plan, employers can contribute the lesser of $58,000 or 100% of an employee's compensation.

The financial takeaway

At its core, the tax advantages of a profit-sharing plan offer employers a way to get more money into the hands of their employees. Perhaps even more valuable is how a profit-sharing plan affects the morale of employees. If a profit-sharing plan can help with employee satisfaction and retention, employers may find a profit-sharing plan invaluable in today's economy.

If you're not already participating in a profit-sharing plan, you may want to consider meeting with your financial advisor to see if adding it makes sense for your business.