Profit Sharing Explained for Small Business Owners

The Great Resignation is in full swing– many workers don’t believe that management cares about their needs. So what are small business owners to do? One way small business owners can respond is by providing complete compensation for a job well done. 

While it may seem like small businesses can’t compete with the perks of larger corporations, one place that small businesses owners can contend is by offering profit sharing retirement options to their employees. 

In this article, we’ll cover the main points of how 401(k)s work so you can be prepared to work with a financial planner and get started.

What is Profit Sharing?

Profit sharing refers to any system that allows employees to gain a percentage of company revenue. The most common form of profit sharing is through company retirement plans, and 401(k) is a feature of profit sharing.

How Does a 401(k) Work?

A 401(k) is a class of retirement savings with certain tax benefits and contribution limitations.

401k, IRA, Roth

Tax-deferral Options

There are two classes of 401(k) contributions. A traditional 401(k) uses pre-taxed funds from both the employee and the employer, allowing the employee to grow the most money possible in their portfolio. Employees will pay taxes upon withdrawal and the current tax rate, typically after age 59 ½. 

The second class of contributions is a Roth 401(k), which uses taxed money from the employee. If you are offering a match, your contribution will still be pre-tax. While less popular, some employees prefer to know that their taxes are already paid or avoid paying taxes in a higher tax bracket after retirement.

401k, IRA, Roth

Contribution Limits

The IRS determines the amount that both employees and employers may contribute to 401(k)s, reviewing the limits each fall to adjust for inflation or other economic impacts.

The 2022 limits are:

  • $20,500 for employee contributions to their own 401(k)
  • An additional $6,500 for employees over 50 (Catch-up Period)
  • Total contribution cap per person is $61,000 annually

There are other rules to ensure fair compensation and that highly compensated employees aren’t skirting taxation. Working with a financial professional will ensure that you comply with all current contribution limitations.

Contributions are due at the same time you file annual taxes.

Customize to Meet Employee Targets

In addition to offering a matching contribution, companies can provide flexible products to meet employees’ individual goals. 

  • Basic Employer Formula: Offer the same percentage match to all employees within the IRS allowance.
  • Integrate with Social Security: This integrated option allows for contributions to be more favorable for employees that make more than the base income for Social Security.
  • Tiered Employer Formula: In this scenario, you divide employees into categories and contribute accordingly. Typically owners or upper management are given a higher percentage, with rank-and-file employees receiving a lower percentage. Fair warning: this method is subject to higher testing, including age-based discrimination.

Other Options: Don’t see a good fit yet? You may want to explore a Defined Benefit Plan or a Cash Balance Plan. Talk with a qualified financial planner to explore your options and make the best choice!

Things to Watch For

Like every good thing, there are a few ways that offering 401(k)s can incur costs and extra time. Understanding the system can help you to avoid unnecessary fees and missing deadlines.

ERISA Compliance

401(k)s include compensation and tax deferral, so the IRS closely monitors it through ERISA guidelines. ERISA (Employee Retirement Income Security Act) ensures correctly reported taxes and overall compensation and that employee compensation is fair across the company. 

Monitoring by ERISA does cost money. That’s why many small businesses apply for safe harbor.

Safe Harbor

The term “safe harbor” can refer to several applications in businesses, finance, and real estate. In general, it refers to any attempts to shelter a company from severe consequences legally. 

The 1996 Small Business Job Protection Act extended safe harbor for 401(k)s to assist small businesses in simplifying requirements. Few small businesses offered 401(k)s because the legal code was too complicated. Now, many more small businesses have felt safe offering 401(k)s with safe harbor.

Keep in mind that the deadline for Setting up a safe harbor 401(k) plan is October 1st.

Whether or not you use safe harbor, it’s a great idea to plan out your retirement offerings with a qualified financial advisor.

Ready to Start Profit Sharing?

At Blu Financial, we specialize in partnering small businesses with the best suite of financial services– including creating their retirement offering for their employees. Contact us today for a free consultation! 

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