The SECURE Act and Profit-Sharing Plans: More Time, More Savings
The SECURE Act (Setting Every Community Up for Retirement Enhancement) was passed in late 2019 to help address the retirement crisis. The goal is to increase savings through a variety of provisions that make retirement plans more accessible to a wider range of businesses. Many provisions went into effect in 2020, but new rules are being introduced in 2021.
For businesses, one of the most significant changes is the Pooled Employer Plan (PEP). This groundbreaking plan makes it easier for small and mid-sized businesses to offer a 401(k) plan by simplifying administration and reducing risk.
In addition, the SECURE Act is giving extra time for employers to start 401(k) profit-sharing plans that can be retroactively backdated to the prior year, starting with 2020. While this extension does not apply to traditional 401(k) plans, employers who want to start a profit-sharing feature may qualify.
What is a 401(k) profit-sharing plan?
A 401(k) plan with a profit-sharing feature allows an employer to make contributions to their employees’ 401(k) accounts based on the company’s profits. This is more flexible than an employer match, which is a fixed contribution. The employer has the discretion to make a contribution or not, based on company profitability or business needs.
In other words, if a business has a good year, an employer may want to make a generous contribution. But if the company underperforms or needs to make capital investments, the contribution can be adjusted. Some employers use profit sharing instead of an annual bonus, which makes it attractive to employees because it may sometimes be a greater amount.
Maximizing the power of profit-sharing
When an employer combines profit-sharing with a 401(k) match, they maximize their tax deductions. Employees can contribute up to $20,500 per year to their 401(k) plan. If the employer makes a match to the 401(k) AND contributes a profit-sharing distribution, the employee’s total pre-tax contribution can be increased to the IRS limit of $61,000 per year and can increase the employers’ tax deduction. With this example, the employer can claim a tax deduction for both the employee match dollars and the contributions from the profit-sharing plan.
The SECURE Act “look-back” period
The new provision of the SECURE Act extends the deadline for starting a profit-sharing plan and allows an employer to backdate it to the prior year (starting with 2020), thereby increasing their tax-deductible contribution, similar to what many businesses do with a SEP IRA.
For example, say your company wants to start a new profit-sharing plan a few months into 2021 because they missed the deadline of Dec 31, 2020 to start a new 401(k) plan. The SECURE Act provision allows a business to retroactively make a contribution to their employees for 2020 through a profit-sharing plan, up to their corporate tax deadline. This is advantageous for many small businesses whose final financial reports are on a different schedule. The new extended deadline allows them to start a new plan, retroactively apply the tax deduction, and get a jump on individual retirement savings.;
Types of profit-sharing plans
Generally, there are three types of profit-sharing plans: pro-rata, new comparability, and age-weighted. When combined with a 401(k) plan, the “new comparability” plan is one of the most flexible ways to maximize retirement contributions while minimizing total cost to the business.
Benefits of New Comparability Method
- Up to $61,000 in annual contributions may be allocated to an individual’s 401(k) retirement account.
- Plan contributions can be deducted as a business expense.
- The plan applies to any size business, even where there’s a wide range of compensation.
- The business owner can define employee categories (for example, salaried and hourly employees).
- Groups are assigned different contributions, which are typically a percentage of pay.
- A minimum contribution is required, based on nondiscrimination testing.
- For workers 50 and over, a catch-up provision permits extra contributions.
SECURE Act Extension Guidelines
Employers may adopt a new qualified retirement plan as late as their business tax filing deadline, including extensions. Here are the requirements:
- Plans adopted by the filing due date for the year may be treated as in effect as of close of the year.
- The plan adoption date used is 12/31 (last day) of the taxable plan year for the adoption agreement and operations purposes.
- This extension will NOT apply to certain plan provisions, such as elective deferrals.
- This allows employer contributions to be made for the taxable plan year.
- Allocation of the employer contribution is based on full year compensation (determination period).
- Effective 1/1/2020
Why start a 401(k) with profit-sharing?
One of the biggest benefits of a profit-sharing plan is flexibility. Contributions are made at the discretion of the employer, depending on the economic success of the business and based on the business’ needs. Any size business can qualify, and a wide range of compensations is acceptable. Contributions are pre-tax, tax-deductible, and not subject to withholding tax such as Social Security or Medicare.
Last but not least, a profit-sharing plan can be an attractive benefit for recruiting potential employees and retaining your best talent.
Questions? A retirement expert can help you learn more about the benefits of profit-sharing plans.