The following post is written by Stuart Robertson, General Manager at ShareBuilder401k. It originally appeared on Forbes.com on November 1, 2011.
When the IRS recently announced new initiatives that will increase 401(k) contribution limits, the one that drew the greatest attention was the increase in employee contribution limits from $16,500 to $17,000.
However, there’s another change that’s just as important for small business owners looking to maximize their savings while minimizing next year’s taxes: it’s the annual tax-deferral limit. This is the annual amount any individual employee can contribute and receive into their 401(k) plan in a given year. For 2012, the tax-deferral limit increases from $49,000 to $50,000 (or $55,500 if you are 50 years of age or older).
Employer contributions help grow your savings.
Employer contributions are what can help some employees, including owners themselves; reach the tax-deferral limit. Most 401(k) plans offer an employer match– which is great incentive for employees to both save as well as stay with their company. It’s also an important piece of building towards the tax-deferral limit. Many employers provide a matching contribution of up to three to six percent of an employee’s W-2 wages. But that won’t get most people near the limit. The key component to do so is Profit Sharing.
The ins and outs of 401(k) profit sharing options.
An optional feature that any employer can use in maximizing contributions is to share some of the profits into employee 401(k) accounts. Because employer 401(k) contributions, which includes profit sharing, are tax deductible for the business and benefits the owner’s 401(k) account too, it’s a common practice for many businesses to execute during years they perform well, and not in years the business may have weaker results.
A standard profit sharing plan provides the same percentage of salary contributions to every employee in the firm directly into their 401(k) account. So with a three percent profit share, an employee earning $100,000 would receive an added $3,000 in their 401(k), and one earning $50,000 would receive $1,500. Additionally, the percentage to share can be determined after year-end but prior to the annual tax deadline (typically March 15 for corporations and April 15 for partnerships, sole proprietors and other business structures for those on a calendar fiscal year). This profit sharing component is also popular with the self-employed who can use the profit sharing component with their Individual 401(k).
Advanced profit sharing enables even more control.
While a standard profit sharing model is the most commonly used in a 401(k), advanced profit sharing is the preferred plan design for businesses with consistently strong profits and fewer than fifty employees. This profit sharing design enables employers to profit share different salary percentages based on unique employee groups within a company.
For example, a legal firm typically has partners, attorneys, as well as support staff that make up the practice. Each group is distinct, has differing compensation levels and is essential to the firm’s success. A different percent of salary can be provided as a profit share for each defined group to reward employees based on the group’s role, compensation or age. A new comparability analysis is done by the company’s 401(k) provider or advisor to determine the optimal levels that best meet the business’ compensation objectives. This can be great for the employees and a smart way for the firm to better manage the rewards of sharing profits too.
If you already have a 401(k) plan and think this can benefit your company, talk to your provider about how you can best use the profit sharing feature to meet your business goals. If you’re thinking of starting a 401(k) plan for 2011, you can typically purchase a plan until mid-December and you will have until near your tax deadline to make any profit sharing contributions for 2011.