Profit Sharing Plan
A profit sharing plan is a type of defined contribution plan that lets companies help employees save for retirement. With a profit sharing plan, contributions from the employer are discretionary. That means the company can decide from year to year how much to contribute (or whether to contribute at all) to an employee's plan. If the company does not have a profit, it does not have to make contributions to the plan.
(But a company does not need to be profitable to have a profit-sharing plan.) This flexibility makes it a great retirement plan option for small businesses or businesses of any size. Plus it aligns the financial well-being of employees to the company's success.
Profit Sharing Plan Maximum Contributions
While there is no set amount that must be contributed to a profit-sharing plan each year, there is a maximum amount that can be contributed to a profit-sharing plan for each employee. The amount fluctuates over time with inflation. The maximum contribution amount for a profit sharing plan is the lesser of 100% of compensation or $54,000 in 2017. Additional, the amount of your compensation that can be taken into consideration when determining employer and employee contributions is limited. The compensation limitation is $270,000 in 2017.
How a Profit Sharing Plan Works
Unlike 401(k) plan participants, employees with profit sharing plans do not make their own contributions.
But a company can have other types of retirement plans, such as a 401(k), along with a profit-sharing plan. Employees can get their profit shares in the form of cash or company stock. Typically, contributions are made to a qualified tax-deferred retirement account that allows penalty-free distributions to be taken after age 59 1/2.
Some plans offer a combination of deferred benefits and cash, with cash being distributed and taxed directly at ordinary income rates (sort of like a retirement contribution plus an annual bonus). If you leave the company, you can move assets form a profit-sharing plan into a Rollover IRA. Distributions taken before age 59 1/2 may be subject to a 10% penalty. While still employed, an employee may be able to take a loan from a profit-sharing plan.
Who Does What in a Profit Sharing Plan
Employees really don't have to do anything to benefit from this type of plan, but the company does have to do some calculations, planning and paperwork.
If the employer does decide to make a profit-sharing contribution in a given year, the company must follow a pre-determined formula for deciding which employees get what and how much. An employee's allocation is typically determined as a percentage of pay. Contributions can also vest over time according to a set vesting schedule.
The employer must also set up a system that tracks contributions, investments, distributions, and more, and file an annual return with the government. These plans can require a good deal of administrative upkeep (but many plan administrators will do this work on the company's behalf).
Pros and Cons of Profit-Sharing Plans
If an employer establishes a profit-sharing plan they may also choose to maintain other retirement plans. There are no size requirements for the company and employers do not need to worry about annually filing a Form 5500. A profit-sharing plan may be designed to be as simple or as complex as the employer desires. It is possible to purchase a pre-approved profit-sharing plan document from a retirement plan benefits professional or financial institution to help lower the burden of administrative work.
Contributions are made on a discretionary basis and this flexibility is an appealing feature of profit-sharing plans. This flexibility makes profit-sharing plans a good option when cash flow is an issue. One potential downside is that the administrative costs have the tendency to be higher than under more basic arrangements (SEP or SIMPLE IRA plans).
Another administrative requirement is the need to test that benefits do not discriminate in the favor of any highly compensated employees.
Profit-sharing plans allow for employer contributions only. In the event that a salary deferral feature is added to a profit-sharing plan, it would then be defined as a "401(k) plan."
The content on this site is provided for information and discussion purposes only. It is not intended to be professional financial advice and should not be the sole basis for your investment or tax-planning decisions. Under no circumstances does this information represent a recommendation to buy or sell securities.
Updated by Scott Spann