Profit-Sharing Plans: What Are They?

In the U.S., approximately 6 million small businesses employ around 32.5 million people.

Many of these businesses provide limited employee benefits, either because most employees don’t qualify or because the state doesn’t require it. Retirement plans are one of the concerns for companies that provide benefits, especially for long-term employees.

Businesses can go a couple of ways with those benefits, such as the popular 401k programs, simplified employee pensions, or simplified IRAs. However, many employers either don’t know about or overlook another choice: profit-sharing plans.

Not sure what profit-sharing plans are or how they work? Keep reading to learn more about this kind of retirement plan.

What Are Profit-Sharing Plans?

When many people think about small business finances, they think about doom-and-gloom stories of business owners barely eking out an existence and tiny profit margins. Many small businesses teeter on the edge of financial oblivion for years at a time. Yet, that’s not every small business.

Some small businesses, often those edging up into medium-sized or bordering on large business territory, enjoy solid revenue streams with healthy profits. Firms like these often consider profit sharing a viable option for their employees as a retirement plan.

In essence, these plans allow a business to designate part of its profit for rolling into employee retirement plans. Companies that take this approach also give themselves some breathing room. If the business doesn’t make a profit in a given year, they aren’t required to contribute. 

The business doesn’t give the money directly to employees. Instead, in most cases, the money goes into a specific retirement account that includes tax deferral.

What Are the Limits?

It turns out that the business can designate as much of its profits as it wants to profit share. The government doesn’t put a hard cap on that. There are, however, limits to what any specific employee can receive as part of a profit-sharing plan.

The amount changes periodically. As of 2022, an employee can get a maximum amount of $61,000, assuming they qualify. The other hard limit is a percentage of the employee’s salary for the year.

Let’s say that you work for a company that does profit sharing and make $57,000 this year. The maximum amount you can get in profit sharing is 25 percent of $57,000 or $14,250. Also, any salary beyond $305,000 doesn’t count toward determining your profit-sharing amount.

Of course, most businesses don’t make enough in profits or designate enough of their earnings to come anywhere near those limits. So, how does it usually work?

Let’s see this in the next section.

How Does Profit Sharing Usually Work?

The way profit sharing usually works out is that the company assigns a specific percentage of its profits for sharing. So, let’s say your company cleared $750,000 in profit last year. They settle on 10 percent or $75,000.

Most companies prefer a comp-to-comp approach to profit sharing, which assigns shared profits based on your percentage of total compensation. So, let’s say that your employer spent $500,000 on compensation. They calculate your percentage as follows:

57,000/500,000 = 0.114 or 11.4 percent

Your employer then assigns you 11.4 percent of the $75,000. That works out to $8550 that goes into your profit-sharing retirement account.

While comp-to-comp isn’t the only possible approach, it’s popular for several reasons. For one thing, it simplifies the math. That can prove vital as the number of employees in a business grows.

Also, the calculations themselves don’t play favorites. While people may gripe because of perceived favoritism in people’s actual salaries, they can’t complain that the math played favorites.

Benefits of Profit-Sharing Plans

Profit-sharing plans offer many benefits for both employees and businesses. On the employee side, a profit-sharing plan can prove more valuable over time than a traditional retirement plan.

Let’s say you work for the company in the last section but only make $14,000 a year. Your slice of the profit-sharing plan works out to $2100.

Let’s compare that with a traditional 401k.

Let’s say you contribute an average of 7 percent, which is about $980. Your employer matches your contribution at 3 percent of your annual salary to the tune of $420. Your 401k contributions for the year work out to $1400—or $700 less than the profit share.

Profit sharing works for businesses in that it can help employees feel a deeper investment in a business’s success. That can contribute to improving productivity levels.

It’s also a way for businesses to show they appreciate their employees, which has obvious benefits in terms of morale and goodwill. Yet, it doesn’t put an onus on companies to contribute when no profits exist.

Setting Up Profit Sharing

Like most retirement plans, profit-sharing plans involve a lot of paperwork and administrative oversight. You might put your HR department at work on it, but it’s a task that is best left in the hands of a chief financial officer.

Of course, many small business owners pull double or triple duty as the de facto CEO, CFO, and COO. For something like this, you want an experienced CFO to make sure you tick all the boxes in terms of tracking contributions, monitoring investments, and ensuring timely distributions of funds when the time arrives.

If you don’t have a CFO, you can look for outsourced CFO services to handle issues like retirement planning.

Profit-Sharing Plans and You

Profit-sharing plans offer business owners or company management teams a way to show appreciation for their employees. It also comes with the bonus of boosting morale, employee investment in the business, and even productivity.

Businesses can even set up profit sharing in addition to a more traditional retirement plan like a 401k or simplified IRA. That way, employees can make their own investments in retirement and enjoy added security in the form of profit-sharing distributions down the road.

Bennett Financials offers a range of business financial services, including CFO services. For more information, contact Bennett Financials today.