Profit Sharing Plan
A Profit Sharing Plan is a type of defined contribution employee benefit plan that is sometimes used as a supplement to a primary defined benefit retirement plan. Profit Sharing Plan offers employees a chance to share in their company’s success. The level of company success is directly related to profits, which often define the amount of profit sharing allocation, so the greater the profits of the company, the larger the potential allocation.
However, profit-sharing plans can serve several goals. If the plan is cash only, it is generally viewed as a form of bonus. If profits are good, benefits are paid. However, these can become viewed as certain, and employees may spend anticipated benefits before they materialize. Deferred plans are generally intended to supplement other retirement plans and thus are generally more appropriate for retirement purposes.
Because of their advantages to both employees and employers, profit-sharing plans can play an important strategic and tactical role in employee benefits planning.
Types of Profit Sharing Plans
There are three basic types of Profit Sharing Plans.
- Cash Plan: At the time profits are determined, contributions are paid directly to employees in the form of cash, checks, or stock. The amount is taxed as ordinary income when distributed.
- Deferred Plan: Profit-sharing contributions are not paid out currently but rather are deferred to individual accounts set up for each employee. Benefits and any investment earnings accrued are distributed at retirement, death, disability, and sometimes at separation from service and other events.
- Combination Plan: In this type of plan the participant has the option of deferring all or part of the profit-sharing allocation. That portion taken as a deferral is placed into the participant’s account, where it and investment earnings accrue tax free until withdrawal. Any amount taken in cash is taxed currently. For tax purposes, Internal Revenue Service (IRS) qualification of Profit Sharing Plans is restricted to deferred or combination plans.
If you do make contributions, you must establish a formula for determining how the contributions are divided. This money goes into a separate account for each employee. However, since contributions to a profit-sharing plan are discretionary there is no set contribution amount that you must make.
Advantages of a Profit Sharing Plan
- Greater flexibility in contributions – contributions are strictly discretionary.
- As with 401(k) plans, you can make a profit-sharing plan as simple or as complex as you want.
- Can have other retirement plans
- Can be used in a business of any size
Disadvantages of a Profit Sharing Plan
- Administrative costs may be higher than under more basic plans
- Need to test that benefits do not discriminate in favor of the highly compensated employees.
Who Contributes: Employer contributions only
Contribution Limits: Only applicable on Deferred Plans in which its lesser of 25% of compensation or $49,000 in 2009 and 2010 (subject to cost-of-living adjustments for later years).
Filing Requirements: Annual filing of Form 5500 is required on Deferred Plans.
Participant Loans: Permitted.
In-Service Withdrawals: Yes on Deferred Plans, but subject to possible 10% penalty if under age 59-1/2.
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