Profit-Sharing 401K [What Is It And The Pros And Cons]

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The world of retirement planning is complex. Hundreds of plans are available on the market, ready to be offered to employees. One of these types of plans is a profit-sharing 401k, and it can be an excellent one.  

Whether you’re an employer looking for a plan or an employee being offered one, understanding profit-sharing 401k plans can be daunting.

Perhaps you’ve heard about it, and it sounds great, but you want to make sure what you’re hearing is true. Our goal is that you’ll get a firm understanding of the key takeaway points involving a profit-sharing 401k.

Let’s get into it.

Is 401k and profit sharing the same thing?

Profit sharing is a type of 401k, so technically yes, they are the same thing. There are however, some key differences that we will cover in the article, so that you can fully understand them.

What is a profit-sharing 401k?

In short, profit-sharing 401k plans allow the employer to make a lump-sum contribution to an employee’s retirement account sometime after the end of the year, based on company performance. In a way, it’s like being a shareholder of a company without taking on any financial risk typically involved with being an actual shareholder.

The amount contributed based on performance can only be calculated once all the numbers come in.

It also depends on how much the employer personally feels like contributing. For this reason, working for a company whose employer cares for their employees’ financial well-being is essential.

Who can contribute to a profit-sharing 401k?

Only employers are allowed to contribute to a profit-sharing plan.

How is profit sharing calculated?

The profit-sharing formula is simply a percentage of the employee’s salary. The amount is flexible, but the employer must contribute the same percentage to all employees.

The employer may also change the percentage from year to year if the employer deems it appropriate.

If the employer chooses to comply with safe harbor status, the minimum contribution percentage will be 3% for each and every employee.

Profit-sharing 401k benefits

As aptly indicated, the 401k portion of the name means that any contributions to an employee through the profit-sharing 401k plan are tax-deferred.

This means that as an employee, you’d be paying the taxes in your retirement rather than during the current year.

And for the employer, you’d get to deduct your contributions to the employees for the year, reducing your overall tax burden.

In this setup, both the employer and employee benefit due to the reduced tax liabilities.

If you didn’t have any tax deferrals associated with the plan, it’d simply be known as a profit-sharing plan, which is generally more straightforward administratively and cost-wise.

How can I get my profit-sharing money?

In order to get your profit-sharing money out of your plan, take the following steps:

  1. Contact your employer (or previous employer) and ask if they are the plan administrator or have the plan administrator’s contact information.
  2. Ask the plan administrator for a withdrawal form.
  3. Fill out the withdrawal form requesting to withdraw money from your profit-sharing plan.
  4. If a reason is needed, be sure to include the reason. Some reasons may involve needing the money for hardship or just simply wishing to withdraw it now that you are no longer employed by the company offering the profit-sharing plan.
  5. Return the withdrawal form and wait for the approval.
  6. Once approved, wait to receive your check, which is usually sent via mail.
  7. Deposit the check into your bank account.

Can a company have a 401k and a profit-sharing plan?

Almost any business can offer a profit-sharing 401k plan.

There are no minimum or maximum number of employees for you to qualify for such a plan. Even if you wanted to include a regular 401k, you could still supplement it with a profit-sharing 401k plan.

Plenty of traditional 401k plans already offer profit-sharing options with minimal additional cost.

Profit-sharing 401k vs. traditional 401k

Unfortunately for employees, unlike a regular 401k, there isn’t an option for employee contributions throughout the year. Subsequently, there are no matching options. However, matching isn’t as commonplace as it used to be in previous generations, so this hardly makes a difference overall for most.

If you are looking for more retirement plan options, check out SEP vs SIMPLE IRA.

Profit sharing contribution limits

The IRS sets rules that guide contribution amounts. For example, the IRS limits (as of 2021) the total profit-sharing compensation for any individual employee to be:

  • $58,000

That is, unless:

  • 25% of the employee’s salary is less than $58,000. In this case, the employee would be receiving 25% of their salary towards profit-sharing compensation.

Also, the employer is bound by regulations to the following rules:

  • The employer can only use a maximum of $290,000 (as of 2021) in salary to consider an employee’s compensation amount. If an employee makes $350k a year, only $290k will factor into the formula.
  • No employee contributions are allowed, as mentioned previously.

Can profit-sharing 401k plans be combined with safe harbor contributions?

Yes, you can combine a profit-sharing 401k plan with safe harbor contributions. You can bypass annual IRS nondiscrimination testing and save on administrative costs by electing to contribute a minimum of 3% to all employees. This can help you and your business reach company goals with fewer headaches along the way.

How does a profit-sharing 401k work?

The way a profit-sharing 401k plan works depends on how your profit-sharing plan is set up. The three types of profit-sharing 401k plans below are the most common ways to set these up:

1. Pro-rata profit-sharing

The most straightforward method. Every employee receives compensation based on the same formula, regardless of their time at the company or level of pay. It could either be a simple percentage applied to all salaries or a fixed dollar amount such as $1,500 for every employee.

2. New comparability profit-sharing

Sometimes referred to as “cross-tested” plans, this one is based on the employee’s current level of compensation. Highly-compensated employees such as the owner and executive members receive a higher percentage of their salary, and lower-level employees receive a smaller portion.

3. Age-weighted profit-sharing

The age of the employee determines the percentage. The closer to retirement, the higher the percentage. This plan creates company loyalty, as it rewards the employees who stay longer with the company. However, this plan is the least popular and rarely used since it no longer considers a profit-sharing pool maximum. As your employees get older, the plan gets more and more expensive. You better be sure your company is growing year-over-year to afford this one.

Profit-sharing 401k examples

Knowing the different plans, how do they play out in practice?

Let’s assume a profit-sharing pool of $25,000 with five employees and a total salary amount of $420,000 for all employees combined.

Using these numbers in the pro-rata plan with a fixed dollar amount, we’d simply do the following calculation: $25,000 divided by 5 employees equals $5,000 per employee.

However, using these numbers in a pro-rata plan with a simple percentage, the calculation involves just an additional step. We need to come up with the magic percentage number that would apply to each employee, regardless of their salary, while still being able to use up the entire profit-sharing pool:

  • $25,000 divided by $420,000 equals roughly 6%. This is the magic percentage to use.
  • Multiple 6% times each employee’s salary to get each employee’s contribution dollar amount.

For both the new comparability and the age-weighted plans, you would use the same profit-sharing pool, but decide on a simple percentage to use for different lengths of employment or age cut-offs. Various plans will outline suggested percentages and you can choose accordingly. Remember, in age-weighted plans, the pre-determined profit-sharing pool goes out the window. As an employer, you may end up spending more than expected.

Take a look at the graph below to get an idea of what numbers to expect for each type of plan.

As you can see, the pro-rata and new comparability columns each add up to about a $25,000 worth of profit-sharing pool. In the age-weighted column, the numbers add up to about $36,000 which is considerably more expensive.

Why do employers offer profit-sharing plans?

Profit-sharing 401k plans are an excellent choice for employers who want to share the financial joys of a growing business without putting themselves too much at risk if there were to be a negative year in profits.

Additionally, it’s a great motivator for employees, as they are much more involved and conscientious of the company’s financial standing. It’s a way for the employees to get rewarded for their year’s hard work. No employee in their right mind would be mad about that. As an employer, you want them on your side.

Who should offer a profit-sharing plan?

Any company offering a profit-sharing 401k should be in a stable trajectory financially.

It’s not a one-and-done situation. You have to intend to keep the plan in perpetuity. Even though you can change the formula on a year-by-year basis, you can’t be carrying out the program one year, skipping the next, and getting back into it later whenever you feel like it.

If a company is waiting to see a positive ROI for years on end, employees won’t be happy seeing nothing contributed during that time. Especially if your company doesn’t offer a regular 40k plan alongside it. Remember, these factors affect each employee’s ability to retire. For some, 401k plans are their entire retirement plan, and if that’s what they truly depend on, you can bet they’re not going to stick around with a company performing negatively year over year.

How much does a profit-sharing 401k plan cost?

Costs vary widely depending on how hands-off you want to be. You’ll need to account for the following:

  • Administrative costs
  • Designation of a fiduciary
  • Creation of a trust
  • Designation of a trustee
  • Software costs

Implementation is an added cost to a company no matter how you spin it; there are no free services. You either must purchase a plan or come up with one yourself. However, it may not be wise to trade time for dollars by doing it yourself. True, pre-designed plans can get relatively expensive, but there are also options for adding a profit-sharing plan to your traditional 401k plan for minimal to no additional cost.

In conclusion

If you’re seriously considering a profit-sharing 401k plan for your employees, it can be hard to navigate the never-ending complexities.

Fortunately, Fidelity offers a profit-sharing 401k plan that works for the majority of business owners. If you’re interested, be sure to check them out.

Of course, research is prudent, and it would be wise to consult with a company that doesn’t sell its own profit-sharing 401k product. We recommend consulting with Betterment for this, as they will guide you with specific advice tailored to your needs.

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