A pension plan is a must for any business, regardless of size. It’s the key to attracting and retaining workers, though there are different options out there you have to think about. So, what’s the difference between a profit-sharing plan and 401(k) for small businesses?
Although both pension plans are similar, they have slight differences that will help put advantages and disadvantages in perspective, helping you choose the perfect plan for your small business.
A profit-sharing plan is a pension plan that allows employees to receive a piece of the company’s profits. The company decides how big of a percentage that would be, and employees will reap a bigger reward if their productivity increases.
The workers may act like owners, and it has better tax benefits for employees
It may lead to meritless pay rise and negatively impact salaries
A 401(k) is a pension plan that allows employees to invest a percentage of their monthly salary in an investment account.
It is alluring for employees and has better tax benefits for businesses
It makes commitments regardless of context, and it is hard to have your money before your retirement
More than half the workforce thinks about retirement one way or another, no matter how long they’ve been working. That means employers must consider the right pension plan for their employees. Learning about a profit-sharing plan and 401(k) is key for that.
What is a Profit Sharing Plan?
A profit-sharing plan is a pension plan that allows employees to receive a piece of the company’s profits. The company decides how big of a percentage that would be, and employees will reap a bigger reward if their productivity increases.
The most important features of a profit-sharing plan are not set in stone. How often do companies share their profits (quarterly or annually) and other details is up to each company. At the same time, companies can change how much they’ll contribute yearly. (Related: The Types of Profit Sharing Plans Small Businesses Owners Need to Know About)
Advantages of Profit Sharing Plan
Unlike having a 401(k), where employers match employee contributions, a profit-sharing plan makes workers feel like they are part of the company, motivating them to go the extra mile into retirement.
Workers act like owners.
Workers see a direct relationship between their own personal gain and company productivity when they have a profit-sharing plan. That means employees tend to take a level of responsibility similar to the one an employer has. At the same time, the more an employee sees how their contribution affects the business (and their profit line), the more involved they will be. A profit-sharing plan turns a regular 9-to-5 grind into an ownership-like scenario. When your money’s on the line, clocking out feels different.
Better tax benefits for employees. One of the great things about this type of pension plan is how employees will handle taxes. Or, better said, when they will handle taxes. Fortunately, workers have to pay nothing to the IRS until it’s time to cash out. That’s a good thing. If you don’t have to pay taxes until it’s time to retire, employees will see their pension fund grow at a faster rate than it would if you had to take a piece of it for taxes every month or year.
Disadvantages of Profit Sharing Plan
Unfortunately, a profit-sharing plan doesn’t come without losses. Motivation is a huge factor when it comes to productivity, and having this type of pension plan may put the wrong ideas in the mind of your employees.
May lead to meritless pay rises. A profit-sharing plan means
every worker shares the wins. In other words, when the company does better, every employee earns a little extra, no matter their productivity. Because of that, some people may lose motivation and start to see their increased salaries as a right, not a result of their work. When that happens, productivity may nosedive. However, that behavior usually follows a cycle. Salaries decrease as productivity does, so employees start putting in extra effort to compensate.
May negatively impact salaries. Smaller businesses suffer from cash flow fluctuations more than larger companies do. Implementing a profit-sharing plan means employees will see an earning reduction when you have a slow month, which may cause discontent.
What is a 401(k) Plan?
A 401(k) is a pension plan that allows employees to invest a percentage of their monthly salary in an investment account. Employers usually match that contribution (or at least part of it). However, doing so is not mandatory, and some companies are reluctant to contribute, though they’re a minority.
Although matching contributions is a great incentive for employees to sign up, this retirement plan also has some great tax benefits.
Advantages of 401(k) Plan
A 401(k) is alluring for most employees. Knowing employers will match employee contributions pushes workers to give their all, so they can earn more, contribute more, and retire early. It also comes with tax benefits for small business owners.
Alluring for employees. Small businesses have a hard time competing against what large companies offer, though having a 401(k) on the table is very alluring for employees. That means you can put something big on the table when it’s time to hire or retain workers, especially during a recession.
Better tax benefits for businesses. It’s not all about employees. Small business owners need to think about retirement too, even if that seems too hard when you’re working 12- to 16-hour shifts to manage your company. A 401(k) is easy to set up (that means having fewer headaches), flexible enough to give you some breathing room if needed, and grows at a faster rate than any other option. You also have higher contribution limits, which may come in handy when your business does better than usual.
Disadvantages of 401(k) Plan
A 401(k) isn’t a perfect opportunity. It may put employers in a tough spot when the market takes a turn for the worse. At the same time, it puts your money behind a paywall, where you have to pay large penalties to access your hard-earned cash before a stipulated date.
Making a commitment regardless of context. Having a 401(k) will put you in a tough spot from time to time. Most small business owners know the value of a dollar, so investing in stocks and bonds without paying attention is not that much of an option. However, you may not have the opportunity to wait before putting money down in your 401(k) and making matching contributions, which may present a problem if you’re having
temporary cash flow issues. At the same time, it’s even worse when you want to cash out before it’s time to retire.
Hard to have your money before retirement. A 401(k) makes it hard to face unexpected scenarios, like a time when you need liquidity to deal with something. It could be a medical emergency or a business opportunity, though this pension plan has no consideration for such a thing. If you need your money before you’re 59 and a half, you’re paying hefty penalties and taxes, even if it’s your money.
Final Thoughts
Both a 401(k) and a profit-sharing plan have advantages and disadvantages. Employers should pick the perfect option for the type of business they have. Indecisive employers shouldn’t take long to pick one, as a pension plan is a key to attracting high-quality workers.
