A Profit Sharing Plan is another special type of defined contribution (DC) plan under which employers, rather than employees, are the ones making contributions. After the company makes its annual contribution, the total contributions are then allocated to individual employee accounts, generally using the “comp-to-comp” method, but several other methods are also available. Because the contributions to, and earnings on, profit sharing plans are generally not taxed until they are distributed, they can offer significant tax savings for small businesses, as well as help them reach the tax deferral limit of $54,000 (2017).
The history of Profit Sharing Plans
Prior to 401(k) plans, profit sharing plans were an alternative to defined benefit (DB) plans. Originally designed as a way for companies to share profits with employees on a pretax basis, and provide retirement security, profit sharing plans were very popular into the early 1990s. As more companies adopted 401(k) plans, the popularity of profit sharing plans began to wane.
401(k) plans gave employers a means by which they could eliminate their contribution to only the employees electing to make deferrals. Shifting the retirement funding responsibility to employees neutralized the argument for companies to offer profit sharing plans.
Companies sponsoring 401(k) plans in lieu of profit sharing plans may have lost sight of the concept of total compensation, and instead offer a menu of ancillary benefits without a focus on retirement readiness. Employees on the other hand, are feeling less secure about retirement and have little guidance on the preparations they need to make. The end result is employees who are less prepared for retirement, and employers with a misguided sense of the cost/benefits of a profit sharing plan.
Offering a Profit Sharing Plan could be a great idea for your company, especially if there’s a consultant running it.
The rise in popularity of 401(k) plans and the ease of administration has diminished the need for retirement plan consultants. Consultants with the background and knowledge of the nuances of profit sharing plans can make profit sharing plans a viable option for most closely held businesses. A carefully designed profit sharing plan can provide the retirement security employees are looking for, eliminate the added cost employers are concerned about in a very competitive business environment, reap additional tax savings for employees and the employer, and give the business owners a vehicle to maximize their contributions. How is this possible?
Maximizing plan benefits for your business
Internal Revenue Code Section 410(b) became effective January 1, 1989 and states that for a retirement plan to be qualified and receive favorable tax treatment it must benefit a minimum number of employees. The common view by practitioners is that IRC 410(b) is very complicated and is seldom used. My view is quite different.
As prescribed by IRC 410(b), only 70% of the eligible workforce must be included. This “coverage ratio” can be further reduced with a careful plan design. For discussion purposes let’s assume we could reduce the coverage ratio to 35%. This means that out of 100 eligible employees only 35 would have to be included in the profit sharing plan. Building on this point, the next step would be to identify the 35 employees who are key to the company’s success and are serious about planning for retirement.
Based on a series of actuarial assumptions and calculations, and a 30 year working career average, we know that employees need to have 6.25% of their annual compensation earmarked for retirement. Having identified employees who are serious about retirement, we can evaluate their commitment, current earnings, and employer provided benefits to arrive at the optimal base level of compensation. The plan formulas are then structured to maximize the contribution for the business owner while providing a meaningful benefit for select employees.
Profit Sharing Plans benefit both employers and employees.
The evolution of this process renders sustainable outcomes for the employer and employee. The employee feels very secure about retirement and less likely to be hired away by a competitor. The employer has a win because more profits of the business can be shifted to the owners on a tax favored basis without a significant increase in staff cost. It’s not uncommon for the closely held business owner to pick up an additional contribution of 15% of their earned income. If the plan is designed properly there are additional tax savings. The benefits far outweigh the cost.
Profit Sharing Plans: Key Facts
- They can be offered in addition to other retirement plans
- Can be offered to a business of any size, but work best for companies with 100 or fewer employees
- Allow for flexible, tax-deductible contributions
- A good option if cash flow is an issue
- Benefits all employees, from the rank-and-file to the owners/managers
- The annual contribution limits for 2017 are: the lesser of 25% of compensation or $54,000 ($60,000 for participants who are age 50+)
- The plan may allow participants to transfer their benefits when they leave the company
- Employer contributions are discretionary and can be changed from year-to-year depending on the company’s performance
- A Form 5500 must be filed each year
- May have higher administrative costs than other, more basic plan options such as SEP or SIMPLE IRA‘s
- Requires discrimination testing and participant disclosures, including testing to determine that the benefits do not discriminate in favor of highly compensated employees (HCEs)
- The minimum required distributions start at age 70 ½
- There is a 10% early withdrawal penalty if the withdrawal is made before the participant has reached age 59 ½ (some exceptions may apply)