A profit sharing plan is beneficial for an employer as it is flexible, allows for good cash flow management, and rewards employees for the company’s success. Profit sharing contributions are discretionary, and, therefore, the amount and timing of the contributions can vary year-to-year. There is no minimum or maximum contribution required by law. Accordingly, the employer can choose not to make any profit sharing contributions for a given plan year.
If the employer chooses to make profit sharing contributions, there will need to be a systematic formula for determining how the contributions are divided among the plan participants. The most common method for calculating each participants contribution is the “comp-to-comp” method. Under this method, the employer would divide each employees’ compensation by total employee compensation. This ratio would then be applied to the total profit sharing contribution to determine each employee’s allocation.
A profit sharing plan allows for employer contributions only. If an employee salary deferral is included, then it would be called a 401(k) plan. Accordingly, retirement plans can be a hybrid of both a profit sharing and 401(k) plan. These hybrid plans are popular as it allows employees to save for retirement in addition to benefiting from company profits.
While profit sharing plans have many benefits, they do not incentivize employee participation. If an employer desires to encourage participants to make employee contributions, they should consider a 401(k) plan and consider providing employer matching contributions. Different from a profit sharing contribution, the amount of employer matching contributions fluctuates depending on the amount of the employee contributions. As a result, employees are incentivized to contribute as much as they can to obtain the maximum match. While profit sharing contributions may be beneficial from the employer’s perspective, employer matching contributions are usually more rewarding from the employee’s perspective.