The Many Benefits of 401(k) Profit-Sharing Plans
Updated: Aug 18, 2021
If you are an employer looking for an attractive employee benefit that lets you plan contributions around your revenues, consider a 401(K) profit-sharing plan. These plans allow you to make pre-tax deposits to your employees' eligible retirement accounts after the end of each calendar year, providing the flexibility to determine exactly how much you want to contribute based on your finances and goals.
The Top Five Advantages of 401(K) Profit-Sharing Plan
You can pay out tax-advantaged bonuses.
If your company pays employees year-end bonuses, 401(k) profit-sharing contributions can be an excellent part of that plan. They are tax-deductible to your company, don't increase employees' taxable income, and are not subject to federal withholding, all while adding to their retirement savings. These value-added benefits make the 401K profit-sharing contribution a great way to enhance your annual bonus program.
It adds to your ability to reward Highly Compensated Employees (HCEs)
One of the few drawbacks to 401K plans is the annual deferral limit that the Internal Revenue Service places on contributions. These limits ($19,500 in 2021) prevent Highly Compensated Employees from maximizing the amount that can be contributed to their accounts based on compliance limits for nondiscrimination testing. Profit-sharing plans circumvent these restrictions, allowing a combination of up to $58,000 (with an additional $6,500 catch-up if an employee is over age 50) to be contributed as a bonus.
It provides additional flexibility for budgeting.
As lovely as it would be to promise high bonuses for year-end, unpredictable revenues make doing so a recipe for disaster. By paying out bonuses in the form of 401(K) profit-sharing contributions, you can assess exactly what you can afford and make the contribution any time before the tax filing deadline – including any extensions you choose to take. Doing so maintains the ability to deduct the contribution on the previous year's tax return too.
Plans allow contribution vesting.
Bonuses and 401(k) plans are valuable recruitment tools. They can be powerful retention tools when they are structured to vest the employee's tenure. Employees considering leaving in a short time frame will lose any portion that has not yet been vested.
It can be built into your existing 401(k) plan with no additional work.
Signing your company up for a 401(k) plan takes time and effort. Still, once it is in place, you can easily add a profit-sharing plan. Many retirement plan providers will add the program without charging an additional fee.
The disadvantages of profit-sharing plans
When it comes to incorporating profit-sharing plans into a 401(k) plan, there are a few things that need to be kept in mind.
There are limits to how much can be contributed for each employee. The total of employee deferrals and employer deposits cannot be greater than 100% of the employee's compensation.
You are limited on how much you can contribute for any employee a year. In 2021 that limit is $58,000, or $64,500 for employees over the age of 50.
An employee's annual compensation may limit employer contributions. For 2021, no contributions were allowed for employees earning more than $290,000.
Employers can deduct only contributions of up to 25% of total employee compensation.
If you have questions about approaching 401(k) profit sharing for your business, contact our office.