Author: Robert A. Jenkins III, Financial Advisor
As a business owner who is growing a team, you may be contemplating which benefits to offer your employees. One of those benefits may be a retirement savings vehicle. Many of us are familiar with the 401(k), but there is another option called a profit sharing plan (PSP) that may be a good fit for you and your small business.
Since I like to focus on the “why” preceding the “how” in making important decisions, I would like to offer “why” many decision-makers choose PSPs for their organizations, specifically: a PSP is a way to give your employees a vested interest in making the company more successful. For a stricter definition, it is a defined contribution plan under which the employer may determine, on an annual basis, how much will be contributed to the plan itself.
This can be attractive to the decision-maker of a smaller or newer firm. Choosing this type of plan over a traditional 401(k) often alleviates much of the financial pressure of maintaining monthly contributions to the plan itself. Keep in mind that all 401(k) plans are profit sharing plans, but not all profit sharing plans contain 401(k) or match contribution provisions.
As for “how,” let’s explore a few ways to determine if a PSP is best for your organization.
Profit sharing plans: Key things to know
There are two major types of profit sharing plans: deferred and cash. Deferred plans are typically used to get targeted employees to the annual IRS pre-tax contribution limit. This is most helpful if you want to attract employees that you hope to retain for an extended period of time.
In a cash plan, the company pays the bonus directly to the employees in after-tax dollars. This type of plan is designed to motivate employees to make the company more profitable in the near term.
A key attribute of a profit sharing plan is that only the employer can make contributions. For 2019, the employer contributions cannot exceed the lesser of $56,000 to each participant ($62,000 including catch-up contributions if the participant is 50 ½ yrs. of age or older) or 25 percent of the employer’s overall eligible payroll. But I should also emphasize that a PSP may exist without the burden of a new payroll process since connecting it to a 401(k) is an optional provision.
Another desirable aspect of profit sharing contributions is that they give employers a lot of flexibility when it comes to tax planning. Tax advisors are very happy to inform clients considering a PSP of the deductibility of contributions to the plan and that neither the amount nor the deposit must occur until after the “close” of the year. Besides the favorable tax treatment, the ability to fund after closing the year is very helpful for employers’ tax planning – this ensures that an employer doesn’t over-or- under-commit to an amount, whereas many 401(k) plans require the employer to make ongoing contributions throughout the year.
The language of your individual employer-sponsored plan details the formula for allocations to each participant’s portion of each annual contribution (e.g. vesting, cross-testing, conditions of the last day and 1,000 hrs. of service). Profit sharing plans may exist in a trustee-directed, single, pooled trust account or in a participant-directed individual account or both.
Making a decision
Profit sharing plans may offer certain advantages for business owners, but as with anything, there are some limitations to consider. Talking with a trusted financial advisor will help you weigh the pros and cons to determine if this is the retirement savings vehicle for you. Here are a few key things that warrant discussion with your financial professional(s) before making a decision about adopting a profit sharing plan for your firm.
Ideal situations for Profit Sharing Plans
Owner or family-only companies.
Companies who would like to attract talent with the “promise of annual contributions” to their retirement accounts
Companies simply looking for the tax advantages of a retirement plan without the burden or liability of additional payroll processes as a result of a 401(k) provision.
Companies with a Simplified Employee Pension (SEP) looking for more flexibility with eligibility and distribution requirements and/or increased Highly Compensated Employee (HCE) favorability with contribution allocations.
Pros of Profit Sharing Plans
No additional payroll procedures to implement if there is no 401(k) provision.
Gives employers simplicity in plan design and discretion over annual contributions.
Provides benefits to a mix of employees and owner/managers.
Contributions and earnings are generally taxed upon distribution.
Limitations of Profit Sharing Plans
Retirement plans funded solely with profit sharing contributions can be an expensive way to get the maximum annual contribution to targeted employees.
It can be frustrating for employees if they are not allowed access to payroll deferrals through a 401(k).
Robert is an independent Financial Advisor serving clients in the states of California, Indiana and New York. An important aspect of his practice is the consultation of business owners in the selection, due diligence and maintenance of their ERISA and/or non-ERISA retirement vehicles. He is a graduate of California State University, Sacramento College of Business Administration with a concentration in Finance. Growing up as the son of a small business owner and an educator in Silicon Valley, he witnessed a very important lesson that still motivates his passion for working with clients and their families today. Even the smartest and the most talented people often struggle to maintain a suitable work-life balance. As a result, they often need a trusted partner in the most important aspects of their lives. By leveraging Robert’s expertise to navigate the increasingly diverse financial landscape, decision makers win back time. He, Jenine, Miles and Robyn are often found together enjoying the social and outdoor aspects of the greater Sacramento area where they reside.
Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed as provisions are subject to change.
Securities and Investment advisory services offered through SagePoint Financial Inc., member FINRA/SIPC. Insurance services offered through Robert A. Jenkins III are independent of SagePoint Financial, Inc.
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