A profit-sharing plan gives employees a portion of the profits a company earns. This type of retirement plan, which is also known as a deferred profit-sharing plan, provides a discretionary percentage of the company’s earnings to employees. Here’s how to decide if a profit-sharing plan would be a good fit for your situation.
What Is a Profit-Sharing Plan?
Just as its name indicates, an employer shares some of the profits with employees through a profit-sharing plan. When a company has a profitable year, it can elect to pass some of these profits on to employees, based on the arrangements of the plan. If the company does not make a profit, it isn’t required to contribute to the employee’s plan.
This type of retirement plan can be available through a company of any size. “Profit-sharing plans are usually non-contributory, meaning the employer will fund the plan on behalf of the employee,” says Mark Charnet, founder and CEO of American Prosperity Group in Pompton Plains, New Jersey. This is different from other types of retirement plans such as 401(k)s, where individual employees are expected to fund the account. Some employers offer various types of retirement plans for their employees, with a profit-sharing plan being one of the options.
Businesses can set up profit-sharing plans so that employee shares are slightly different. “From an employee standpoint, one should look at the profit-sharing plan as an end-of-year bonus program,” says Brian Halbert, a retirement specialist at WD Pensionmark in Austin, Texas. The amount given can be in the form of cash, company stock or as a contribution to a retirement account.
When given as a contribution, the funds are usually placed in a qualified tax-deferred retirement account. After age 59 1/2, you’ll be able to take distributions from the account. If you withdraw funds before then, you’ll typically have to pay a penalty. Some companies offer combination profit-sharing, such as part of the benefit in cash and another portion contributed to a tax-deferred retirement account. Also, employers may permit employees to take a loan from the profit-sharing plan while they are still working for the company.
Companies can choose how much of their profits they are willing to share with employees, up to the lesser of 25% of employee compensation or $58,000 in 2021. The maximum amount of salary that can be used to calculate a profit-sharing amount is $290,000 for 2021. Employers create plans that indicate how benefits will be distributed. These plans are tested every year to make sure that benefits are being offered in a way that doesn’t discriminate against anyone in the company.
The Advantages of a Profit-Sharing Plan
Since a profit-sharing plan gives employees a portion of the profits earned during a year, the setup can help motivate personnel. A company might establish a goal that employees can work to achieve. This is often “a key revenue goal or a new business goal or something custom to the business,” Halbert says. “It should help align employees to work toward that goal.”
Once they have a profit-sharing plan, employees may decide to stay with a company for more years than they originally planned. This type of plan “encourages employees to buy into the company vision, and further increases employee loyalty,” says David Johnson, a partner at Signature Estate and Investment Advisors in Tysons Corner, Virginia. When recruiting staff, some companies find the plan attracts new talent.
The Disadvantages of a Profit-Sharing Plan
A profit-sharing plan has several drawbacks. Since employers aren’t committed to sharing a set dollar amount, there could be times when employees don’t receive any contributions. If a company suffers losses for several years in a row, employees aren’t likely to receive profit-sharing contributions. This type of plan “might not be the right fit for each business,” Halbert says.
Another potential negative is that companies may choose to compensate employees differently. “As with any form of bonus compensation, employees can develop a sense of entitlement,” Johnson says. This may cause friction between team members or reduce an employee’s overall productivity.
Employees don’t contribute to the plan. Since the contributions are based on what the company offers, some employees may feel that this is not enough for a secure retirement. You may need to open an additional retirement account with your own funds.
When Is a Profit-Sharing Plan a Good Option?
Before signing up for a profit-sharing plan, it can be wise to evaluate your overall retirement plans. Think about savings goals, along with the number of years until retirement. It can also be worthwhile to investigate the company and consider its growth patterns during the previous years.
For employees in growing companies, or companies working to significantly grow in the coming years, a profit-sharing plan might make sense. “If you ask most business owners what their most valuable intangible asset is, they would quickly declare their employees,” Johnson says. “Thus, profit-sharing plans can be a great way for companies to share their success with those that matter most: the employees.”