What Is a Profit Sharing 401 (k) Plan? (vs. traditional plans)

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Retirement plans are essential because its a strategic method of securing your future. 401k plans are the most common type of retirement plan, but what is a profit sharing 401 (k) plan?

A profit sharing 401 (k) plan is a retirement plan where the company makes contributions for eligible employees into their retirement account at the end of the year based on the company’s profits. The total contribution will vary based on the company’s profitability and could be nothing during an unprofitable year.

But that’s just a quick snapshot.

So, in this article, we’ll look at how those are similar and different from a traditional 401k plan. I’ll also cover if there are any downsides and what happens if the company doesn’t make a profit.

Let’s dive in.

What is the difference between a 401k and a 401k profit-sharing plan?

A 401k plan is a retirement plan invested in mutual funds that the employee contributes to. There may or may not be an employer match of funds. In contrast, a 401k profit-sharing plan sees a discretionary contribution from the employer to the employee’s retirement account at the end of the year.

In a way, it’s kind of like the old-school pension plans.

The 401k plan is a savings plan offered by organizations to their employees, and it is government-regulated. Essentially you make your own contributions, in whatever amount you wish each month into your 401k.

Many people just have their employee contributions set to 15%.

BUT in a traditional 401k, the money is put in the 401k before-tax contributions. In other words, if you got paid $1,000 but put $500 into the 401k, you would report earnings to the IRS of $500. BUT when you take that money out when you retire, you’ll pay tax on it then.

The 401K plan is an attempt by the U.S. government to encourage workers to save for their future.

You can check out this recent article on my website on the best ways to save for retirement. After all, a 401k isn’t the only option, and what do you do if you’re a sole proprietor? And how much money do you really need?

Just click that link to read it on my site.

Aside from the traditional 401k, there’s also a Roth 401k which some employers may offer.

The traditional 401k is a plan that deducts the agreed amount before income tax is removed.

Therefore, the employee does not pay any tax on the money until withdrawal. On the other hand, Roth 401k involves setting aside a certain amount after-tax deduction. Therefore, you don’t have to pay tax on withdrawing the money after retirement.

The 401k profit-sharing plan is often confused with regular profit-sharing plans, where the employer gives the employee a portion of the company profit. However, this is dependent on various factors.

With a 401k profit-sharing plan, employers can contribute to their employee’s retirement account at the end of the year. But plan contributions might not be anything, depending on the profit.

So, if there’s no profit, you might not see anything.

So, while a 401k profit-sharing plan isn’t necessarily bad, I would not have that as my only method of saving for retirement, especially when working for small businesses.

If the company had a lot of profitable years, you may be set. But if it was only profitable half the time, your retirement benefits might be much smaller than needed.

Can you lose money in a 401k profit-sharing plan?

A 401k profit-sharing plan can lose money, as can any retirement plan that is invested in mutual funds. However, the biggest danger with 401k profit-sharing plans is inconsistent contributions based on the company’s profitability.

But yes, it is quite possible to lose money in a 401k profit-sharing plan.

Most retirement plans use mutual funds to invest the money in. I personally love mutual funds since each fund is a collection of stocks around a common theme.

1 stock can go up or down wildly. So, with mutual funds, the idea is that by having several stocks in 1 fund, some might go up while others go down, minimizing the risk.

The allocation method I use is to invest in at least 4 different, unrelated mutual funds. I also like ones with a 15–20-year track record. And I like to make sure their average earnings over that time are at least 10%.

But as I’ve said, the biggest risk is the lack of employer contributions if profitability is low or non-existent. So, this type of plan, if it’s your only retirement plan, is risky!

You can keep the risks at bay though if you have emergency funds. 

Not sure how this works? You can read a recent article on my website on the benefits of emergency funds. But do you really need 6 months of expenses in there?

Just click that link to read it on my site.

What are the disadvantages of profit-sharing?

Profit-sharing disadvantages include the uncertainty of how much the employee might receive. This causes frustration among employees who see detrimental business practices affecting profitability but lack the authority to change them. It also doesn’t take employee performance into account.

Let’s review some of those in greater detail:

Uncertainty

One major disadvantage of a profit-sharing plan is that you cannot be sure of anything.

The profit shared greatly varies depending on the organization and the total revenue generated at the end of the year. Also, the company may make very little profit despite the best efforts of the workers to produce maximum output.

In addition, the profit-sharing plan makes it impossible for workers to plan for the money as they are not sure of it. When the company is struggling to make tangible profits, it may discourage workers from giving their best.

Disregard for work effort

There is no distinction between efficient and inefficient workers in the profit-sharing plan. So, the talented worker gets the same benefit as the lazy one.

There is already a method for calculating the staff’s profit, which depends on different factors. However, disregard for the efficiency and contributions of some workers reduces their zeal to work.

Workers who do not make tangible contributions to the organization will be unmotivated to do more. After all, everyone will get the same share in the profit-sharing plan.

A hardworking staff may be bitter if they perceive that the plan does not appreciate their efforts.

The focus is profit

Another disadvantage of the profit-sharing plan is the absolute focus on profit.

It is no secret that every organization aims to make profits and expand. Consequently, it may inhibit the growth of the workers, which would reflect in the organization’s performance.

In most cases, the leaders in the organization are all about profit. Without that, you are not a functional member. This may lead the workers to disregard what is best for their customer/ client to offer the service that will bring in the most profit.

Without a doubt, this strategy is not sustainable, and it may lead to loss of customers eventually.

Feeling of entitlement

Suppose an organization is doing well and the workers receive a good share from the profit-sharing plan.

But unfortunately, the company may not make a good profit in another year.

This will lead to grumbles and murmurs amongst the workers. Gradually, the workers lose motivation to work, and productivity further declines.

Cost of planning profit-sharing

The cost of planning and implementing a profit-sharing plan may cause the organization to incur additional debts. In addition, giving away part of the company’s profit reduces the available revenue for investment.

This may become a problem as you satisfy your workers at the expense of the organization’s growth.

Why would a company adopt a profit-sharing 401 k plan?

A company may adopt a profit-sharing 401k plan as an incentive to motivate employees by boosting their total compensation to help make the company more profitable. But the employer contributions are also 100% tax-deductible.

And there are also no maximum contribution limits as there are with traditional 401k plans.

Let’s explore those and a few others in greater detail:

Tax Benefits

One of the primary reasons companies adopt this plan is that they are tax-deductible.

Therefore, it may serve as the end of the year bonus, making the workers happy. Furthermore, the profit-sharing 401k plan helps employees develop their retirement funds further without fear of increasing taxes within the year.

In addition, Social Security or Medicare withholding does not affect profit sharing. Furthermore, an end-of-the-year bonus to staffs’ retirement plans may be more appreciated than an actual instant payment.

Flexibility

Another reason a company may want to adopt this plan is the flexibility that comes with it. Bosses may be unsure about what to give their employees.

Small business owners don’t need to be committed to a specific annual bonus. And they can pay less in employee’s compensation with the idea that at the end of the year, everyone benefits if it was a good year.

Saves time

Putting a profit-sharing 401k plan into motion is timesaving as most organizations already run a 401k plan for their employees.

Therefore, they incorporate the same method in sharing profit in the profit-sharing 401k plan. You can get one team to manage the plan to get the calculations and sharing right.

The maximum contribution for highly compensated employees

The IRS describes a highly compensated employee as a worker who owned more than 5% of the business interest during the previous year.

In addition, it may be a worker who received $130,000 or more in compensation from the employer that boosts their 401k plan during the last year.

Therefore, a profit-sharing plan allows for maximum contributions to highly compensated employees without getting in trouble with the IRS. In addition, it will enable you to be within the IRS compliance limits for nondiscrimination testing.

Vesting Schedule

The vesting schedule is a program developed by the employer to give their employees access to certain profits if they meet the requirement. It is usually based on a specific length of service.

Therefore, if an employee leaves the organization before their contributions are fully vested, they make losses. On the other hand, vesting can promote retention and dedication of workers, so they receive more contributions to their 401k plan.

Improves employee and staff relationship

A profit-sharing 401k plan benefits both employer and employee.

Therefore, it serves as a bridge for a cordial relationship between both parties. The employee would not slack from their duties because they know it would reflect in the percentage of the profit that would be contributed to the 401k plan.

Similarly, the employer would respect hardworking staff as they are jointly responsible for the organization’s increase in profit and growth.

Can you roll over a profit-sharing plan to a regular 401k if you leave the company?

A profit-sharing plan’s vested proceeds will need to be rolled over to an IRA when leaving the company and cannot be rolled into a traditional 401k.

First, however, you have to consider the company policy on vesting.

The rollover process is straightforward, considering you follow the IRS rules for rollover. Three rollover options are available, and they include:

Direct Rollover: in this option, plan participants receive earnings in a check payable to a new IRA account. Then, you take it for deposit into the IRA account.

You don’t have to pay tax for this rollover process. This is the method you want to use.

Indirect Rollover: in this process, the check is made out to the participant’s name and not to the IRA account name, as seen indirect rollover.

The trick here is that the administrator of the profit-sharing plan will hold on to 20% of the total revenue.

However, the check must be deposited into the IRA account within 60 days, or you have to pay tax on it. Failure to make a 100% deposit incurs a 10% tax rate at the end of the year.

Trustee-to-Trustee Transfer: This is the revenue transfer between the institution holding the profit-sharing plan and the IRA institution.

In this method, you do not receive any checks or taxes for the transaction. Therefore, this is the safest way to rollover your earnings with little or no difficulty.

Does a profit-sharing 401 (k) get taxed?

The money an employer puts into an employee profit-sharing 401k is tax-deductible for the business, and the employee only pays tax when they withdraw the money.

The biggest difference is that since the employee isn’t making contributions as they would in a regular 401k, they aren’t reducing their overall taxable income.

BUT, just like a regular 401k, these employees’ retirement accounts don’t get taxed until you cash out. And as long as you wait until retirement age (currently 59 ½), you won’t pay any penalties to do that.

One thing you could do, especially if you envision being in a higher tax bracket once you hit retirement age, is to roll it over into a Roth IRA. That would have you paying tax now, but it will grow tax-free.

What are the rules for profit-sharing 401 (k) plans?

Some rules guide the distribution of funds in the profit-sharing 401 (k) plan. These are the methods of distributing funds:

Pro-Rata Method

In this method of profit sharing, employees receive the same percentage of the profit.

The contribution received depends on individual salary. For instance, suppose the employer decides to contribute 4% to the employees’ profit-sharing 401 (k) plans. Each employee gets an equal contribution of 4% of each employee’s salary.

Integrated Profit Sharing

Integrated Profit Sharing uses Social Security taxable income levels to determine how an employee can contribute to the profit-sharing 401(k) plan.

Social security benefits are often paid below a particular threshold for which high earners may not benefit. However, this plan allows high earners to make up for lost social security compensation by receiving a large percentage of the profit sharing.

New Comparability 401(k) Profit Sharing

This method groups employees when creating a contribution plan.

For instance, in an organization, the executive receives a certain contribution. At the same time, the regular workers get a different portion of the profit. Usually, the executives get a higher percentage of the profit sharing.

Age-Weighted Plans

The age-weighted plans calculate employer contribution based on employee age.

Therefore, the older employee will get a greater percentage of their salary as part of a profit-sharing plan. This can be an incentive for workers to remain loyal to their organization.

How 401(k) Plans Work And Why They Killed Pensions

Conclusion

The 401K plan is where you consciously and intentionally serve a percentage of your monthly salary as retirement funds. A profit-sharing 401k is when your employer deposits money into your qualified plan at the end of the year based on the company’s profitability.

The profit-sharing plan has some advantages, such as increasing the motivation and productivity of workers. However, remember that you can lose money in a profit-sharing plan if you do not understand your companies’ policies. You may enjoy a good life during your work years.

However, what happens when you reach retirement age? Do you have what it takes to live a financially independent life?

Check out a recent article about keys to financial freedom on my website. I get into not only how to have financial freedom, but what that means, why it’s important, and what to focus on.

Just click that link to read it on my site.

Of course, while I have decades of experience with financial accounts, profit-sharing programs, and running million-dollar companies, I am not a CPA, financial planner, or financial advisor. If you need professional financial advice, seek a qualified professional in your area.

Image by Gerd Altmann from Pixabay

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