Profit Sharing Plans

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Profit Sharing Plans

Profit sharing plans offer employers both design flexibility and discretion with regard to contributions. Employer contributions are self-determined and can be allocated in a number of ways. If an employer makes little or no profit during a year, no contribution is required, although an employer is permitted to make contributions even if the company is not profitable

An employer’s maximum deduction is limited to 25% of the annual compensation paid to eligible employees. There are three basic types of profit sharing plans: traditional, age-weighted and new comparability. The differences between the plans are the contribution allocation formulas used for each one

A traditional profit sharing plan follows the salary ratio method, which is designed to allocate employer contributions to all participants on a uniform basis. A profit sharing plan with a salary ratio formula is similar to a simplified employee pension (SEP) plan, but may be more attractive than a SEP plan in situations where an employer

(a) does not wish to cover certain part-time employees,

(b) wants to make employer contributions subject to a vesting schedule or

(c) wants more control over the assets.

The age-weighted method allocates contributions based on both the age and compensation of eligible employees. It is similar to a defined benefit pension plan, but gives employers the option of making discretionary contributions. Since a participant’s age or length of time until retirement is factored into the allocation formula, older participants receive a proportionately larger share of the contribution. This can be advantageous in situations where a company’s key employees are significantly older than its other employees. This type of plan is especially well-suited for small businesses and professional practices.

The new comparability, or cross-tested, allocation method allows an employer to divide employees into different classifications for purposes of allocating contributions. If non-discrimination requirements are met, a larger share of a company’s contribution may be made on behalf of those employees to whom the employer wishes to provide more significant benefits. This type of plan involves complicated calculations and may require actuarial consulting, but it is typically less expensive and more flexible than a defined benefit plan.