Profit Sharing Plans
Profit Sharing Plans are flexible and therefore best suited to new businesses or firms whose income fluctuates from year to year. A Profit Sharing Plan is a Defined Contribution (DC) Plan in which contributions each year are discretionary and cannot exceed 25% of the sum of all eligible participants’ salaries. It is an individual account plan, thus, the ultimate retirement benefit/amount is the actual account value that has been credited with contributions and investment experience through the years. There are various types of Profit Sharing Plans. Each type is dependent on the contribution allocation method and plan features.
An Age-based Profit Sharing Plan is one that uses both age and compensation as a basis for allocating employer contributions among plan participants. This concept is similar to Target Benefit Plans. With a Profit Sharing Plan, contributions are not mandatory. Age-based Profit Sharing Plans, like Target Benefit Plans, tend to favor older, higher-paid individuals.
An Integrated Profit Sharing Plan is a type of allocation method that is integrated with an overall retirement scheme and includes Social Security. This combination is called “permitted disparity.” By providing for permitted disparity in its qualified retirement plan, the employer gets the benefit of Social Security tax payments.
Under an Integrated Profit Sharing Plan compensation is broken out into two parts; the amount above the integration level (excess compensation) and the amount below the integration level (base compensation). Usually the integration level is the Social Security Taxable Wage Base in effect for the applicable year. The employer is permitted to “offset” their contribution to Social Security by applying a lower contribution percentage to the base compensation (i.e., the base percentage) and a higher contribution percentage to the excess compensation (i.e., the excess percentage). There is a limit or “permitted disparity,” however, between the base percentage and the excess percentage. The permitted disparity depends upon the contribution level to the plan. Generally, this type of allocation formula tends to favor higher-paid employees.
In a new Comparability Plan, the employer segregates the eligible employees into “non-discriminatory” categories (i.e., job description, title, hourly vs. salaried, etc.) and designates different contribution rates for each group.
Because of the potential for discrimination in favor of “highly compensated employees” this type of plan is required to perform special tests each year to ensure that the contributions do not violate the IRC Sec. 401(a)(26) and 410(b) non-discrimination regulations. If the plan does not pass these tests, the contribution rates for some/all groups must be adjusted. Also, beginning with the 2002 plan year, each NHCE (non-highly compensated employee) cannot receive a contribution that is less than the lower of 5% of salary or one-third of the highest allocation rate for a highly compensated employee regardless of the results of the non-discrimination tests. Though this type of plan normally favors highly compensated employees, it can be designed to favor any group of employees assuming the annual “non-discrimination” requirements are satisfied.
In a 401(k) Plan participants are able to defer a portion (up to the annual government limit) of their salary into the plan. The funds that are deferred are not included in current income until they are withdrawn from the plan. Amounts deferred into the plan generally may not be distributed without penalty until the employee retires, becomes disabled, dies, or reaches age 591/2.
In addition to employee deferrals, the plan may also provide for an employer contribution. This contribution may be in the form of a Matching Contribution or a Discretionary Contribution. Discretionary contributions may be allocated either as a level percentage of pay for all, or by one of the methods listed.