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Offer a year-end bonus with profit sharing

Offer a year-end bonus with profit sharing

Nicolle Willson, J.D., CFP®, C(k)P®

In the spirit of giving as you wrap up the year, one way to thank your employees is with profit sharing.

What is profit sharing?

Profit sharing is a pre-tax employer contribution made to your employees’ retirement accounts after the year ends. For employers, these contributions are tax deductible, making profit sharing a mutually rewarding benefit.

As an employer, you decide whether profit sharing is right for your business, and if so, how much you'd like to contribute and in what way. There are many different ways to allocate your profit sharing contributions. We’ll cover them below to help you find one that fits your personal and business goals.

Profit sharing vs. a regular bonus

By offering profit sharing instead of a regular bonus, you can help increase your employees’ retirement savings without it being counted towards their taxable income in the year the contribution is made. In this way, profit sharing can be more rewarding to your employees than an outright bonus of the same amount. As the employer, these contributions are both tax deductible and not subject to Social Security or Medicare withholding.

Take advantage of flexible financial planning

Offering an employer contribution understandably takes some financial forethought. With profit sharing, there’s no pressure to make a decision quickly. The flexible deadline for profit sharing plans allow you to decide after the year has ended. As long as you make the contributions before your tax filing deadline (which includes extensions), you will still be able to deduct them on the previous year’s tax return. For example, if after reviewing your business financials in February of 2022, you decide you want to make a profit sharing contribution to your employees for 2021, you can do so then and still get deductions on your 2021 tax return.

Understand your type of contribution

There are a few different ways you can allocate the profit sharing contribution and your plan document provides the formula that applies to your plan. Think of it as how you want to contribute a set amount of money across all of your eligible employees. Guideline offers the following options: 1) same dollar amount method, 2) comp-to-comp method, and 3) new comparability.

1. Same dollar amount: Also referred to as “flat dollar amount,” this method is the simplest because every employee will receive the same contribution amount. It’s calculated by dividing the profit pool amount by the number of eligible employees.

For instance, if the pool is $70,000 and there are 7 employees eligible to participate in the plan, each employee will get $10,000 deposited to their retirement account. Although the individual allocation will be the same across all employees, the percentage of compensation the profit share makes up will vary pretty significantly across employees. ($10,000 to an employee making $40,000 will feel very differently than $10,000 to an employee making $100,000.)

2. Comp-to-comp: More widely known as “pro rata,” this method allocates the profit sharing contribution based on the same percentage of compensation. It’s calculated by determining the percentage of compensation for each employee to total compensation of all employees combined. Following this formula, each employee’s individual allocation should be the same percentage of their compensation.

For example, if the company’s profit sharing pool is $10,000 and the combined compensation of your four eligible employees is $200,000, then each employee would receive a contribution equal to 5% of the employee’s salary.

3. New comparability: Also known as the “Group” or “Cross-testing” method, this type of profit sharing is different from the others because it allows you to give a larger dollar amount share to older, higher income individuals than the rest of the employees, as long as the contributions pass certain nondiscrimination tests. By permitting greater disparity of contributions between different groups of employees, new comparability is the best option for business owners who want to contribute more to their own accounts than to their younger, lower-income employees.

Understanding new comparability

Cross-testing is a type of nondiscrimination testing where a profit sharing contribution is converted to a projected benefit at retirement. Using this technique, employers can create different benefit groups based on expected time to retirement age. Each group then receives a different contribution. Essentially, new comparability works by ensuring that these different contributions made to each employee will result in an equivalent retirement benefit in the future so that NHCEs are not discriminated against in the long run. Guideline will administer the testing and maintenance involved in offering new comparability profit sharing.

New comparability plans are generally better for business owners who are older, have higher salaries than other employees, and want to maximize employer contributions to their own accounts.

A 3% Safe Harbor nonelective contribution is required for Guideline plans that want to use a new comparability formula. This is because new comparability requires a “minimum gateway” contribution of up to 5% to all Non-Highly Compensated Employees (NHCEs), (lesser of a) 5% or b) 1/3 of the highest allocation rate for any Highly Compensated Employee for the Plan Year. New comparability plans also tend to have a higher chance of being top heavy with a 3% top heavy minimum contribution (and the 3% safe harbor contribution counts towards that minimum).

Is new comparability right for you?

New comparability may be a good fit for your small business if:

  1. You’d like to maximize your employer contributions made to owners
  2. Owners are generally older than non-owner employees
  3. Owners receive higher compensation than non-owners
  4. You have a small number of employees (usually fewer than 50)
Retirement 401(k) plans for small businesses

The information here is provided solely for educational purposes only and is not intended to be construed as investment or tax advice. Please consult a qualified tax or financial advisor to determine the appropriate strategy to fit your specific needs.