Profit Sharing Plan
Updated: Sep 7, 2021
A profit sharing plan is a type of savings plan that enables workers to share in the profits of the company for which they work. Businesses of all sizes can offer profit sharing plans and generally do so to help workers save for retirement. However, unlike with most types of retirement accounts, workers cannot make their own contributions to these plans.
If your employer offers a profit sharing plan, they have the discretion to decide both whether to put money into your plan and how much. However, companies are required to establish a set formula to determine how contributions are calculated, so you’ll know what to expect.
What is a profit sharing plan?
A profit sharing plan is a type of defined contribution plan that your employer puts money into in order to help you save for retirement.
Unlike a defined benefit (pension) plan, this type of retirement plan does not provide you with any guarantee of income in your later years. In fact, there is no guarantee your employer will even put money into it each year.
Despite the name, company profitability isn’t actually a requirement for these plans. Your company may contribute to your plan even before it’s profitable. On the other hand, it also isn’t required to provide you with any particular share of profits, as all contributions are discretionary.
DID YOU KNOW?
Profit sharing plan contributions may fully belong to you right away or they may vest over time. This varies between different companies.
How do profit sharing plans work?
When your employer contributes a share of company profits to workers participating in a profit sharing plan, some of the money must go into a separate account specifically earmarked for you.
At most, your employer can contribute up to the lesser of 25% of your compensation or an annual maximum of $57,000 in 2020 or $58,000 in 2021. For those 50-and-over and eligible for catch-up contributions, this annual maximum will be $63,500 in 2020 and $64,500 in 2021. The amount can change annually and no contributions are ever required.
Your employer must provide you with a written document detailing how contributions are allocated among employees. Generally, all employees must be included unless they fall within permissible exceptions, such as if they’re under 21 or haven’t worked for the company for at least one to two years.
Depending on your company, contributions may be fully vested immediately (and thus fully belong to you right away), or they may follow a vesting schedule. If employers require that workers put in two years of service before becoming eligible for a profit sharing plan, then contributions have to vest immediately.
While your company can choose the amount it contributes, contributions among owners and managers must be proportional to those made for rank-and-file employees.
Contributions may be made in the form of cash or company stock. And depending on your plan, you may be allowed to make decisions about how the money is invested once it has been contributed to your account. In other cases your company will manage the money on behalf of you and other workers.
Types of profit sharing plans
Companies can use several different approaches to determine how contributions to profit sharing plans are made. The most common types of profit sharing plans are pro rata, new comparability, and age weighted. Here’s an overview of several popular types of profit sharing plan formulas.
Flat dollar amount: Employers contribute the same amount to every employee’s account regardless of the employee’s compensation level. For example, each employee might receive $2,000.
Pro rata/salary proportional: Each participant receives a portion of the company’s contribution to the profit sharing plan that’s equal to a uniform percent of that participant’s compensation, such as 5%.
New comparability plan/cross testing: Plan participants are divided into classes or groups, each of which has a unique contribution formula. With this approach, highly compensated employees can’t receive a disproportionately higher benefit (as a percent of pay) if the company wants to retain tax benefits.
Age weighted: Contributions are increased for older employees.
Permitted disparity method/Social Security integration plan: Because the Social Security benefit amount is calculated only on income up to the wage base limit, this method allows for larger contributions on income exceeding this limit.
Profit sharing plan rules
If your employer offers you a profit sharing plan, the key rules to be aware of relate to what happens when you leave the company and to when money can be withdrawn. Typically:
Money in a profit sharing plan cannot be withdrawn before age 59 1/2 without a 10% penalty; however, administrators of a profit sharing plan have more flexibility in determining when a worker can make a penalty-free early withdrawal than they would with a traditional 401(k).
Distributions from a profit sharing plan are taxed at ordinary income tax rates.
Participant loans may be permitted, but this is up to plan administrators.
Vested contributions can be rolled over into an IRA when a participant leaves the company.
Profit sharing plan vs. 401(k)
The key difference between a profit sharing plan and a 401(k) is that only employers contribute to a profit sharing plan. If employees can also make pre-tax, salary-deferred contributions, then the plan is a 401(k).
Employee contributions are also always 100% vested in a 401(k), whereas employers contributing to a profit sharing plan can impose vesting requirements. That means you may forfeit these contributions if you don’t fulfill certain minimum work requirements.
Employees get the best of both worlds when an employer offers a 401(k) that allows them to invest for retirement with pre-tax dollars while also offering a profit sharing plan. However, workers don’t get to choose what type of retirement plan employers provide. If your company offers a profit sharing plan but you cannot contribute to it, you may wish to look into other tax-advantaged contribution plans such as an IRA if you hope to invest for your own future.
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