Sharing wealth is a great way to motivate employees. Profit sharing is a popular addition to 401(k) plans, along with bonuses, raises, and other perks. Profit-sharing plans are employer-sponsored retirement plans that contribute pre-tax dollars to employee accounts based on the company’s profitability. Employees of the organization are eligible to participate in profit-sharing at the employer’s discretion. Profit-sharing plans combine flexibility with significant tax advantages for employers and employees and can be advantageous to both.
How does profit sharing work?
An employer can set up a profit-sharing plan as part of an employee’s 401(k) or as a stand-alone plan. Profit-sharing programs give employees a share of profits based on their earnings.
Those participating in the plan will receive a set percentage of profits according to a written plan document. In addition, they must create a trust for the plan’s assets, establish a record-keeping system, and inform employees about the plan.
Employees feel valued when their employers offer profit-sharing plans. According to Shawn Plummer, CEO of The Annuity Expert, profit sharing is a way to motivate employees to increase company profits so they can earn more.
When recruiting new employees, profit sharing is a generous perk. You can also tweak your profit-sharing rules to help retain employees. Employers can motivate employees to continue working for their company by offering them a cliff or graded profit-sharing contribution vesting schedule.
An employer can also decide which employees are eligible for a profit-sharing plan. Those under 21 or working less than 1,000 hours per year can be excluded from the plans. Additionally, employers can use vesting schedules, which give employees a portion of the funds in their accounts over time. Employers can use vesting schedules to reward and encourage employees who stay with a company for longer.
Contributions are calculated according to a set formula by employers.
Employees do not fund a profit-sharing plan; employers fund it. Employers must have a formula for calculating how much money will be put into each account. A standard method is comp-to-comp, which calculates contributions based on the employee’s compensation as a percentage of the organization’s total compensation. Although there is no required profit-sharing percentage, experts recommend between 2.5% and 7.5%.
Despite the plan document’s set formula for contributions, employers can modify the number of contributions each year or forgo them altogether. For businesses that experience volatility throughout the year, profit-sharing plans are especially valuable.
Limits on profit-sharing contributions
For 2022, contributions cannot exceed 100% of an employee’s salary or $61,000. A profit-sharing plan allows employers to increase employee contributions while decreasing their tax burden since most 401(k) contributions are capped at $20,500.
If an employer matches the employee’s 401(k) contributions up to the maximum amount, the employee can contribute $41,000 per year ($20,500 employee + $20,500 employer). By participating in a profit-sharing plan, the company can contribute $20,000 more in pre-tax dollars for the employee to reach the maximum $61,000 allowed by the IRS.