OVERVIEW OF PLAN TYPES

An employer who decides to sponsor a retirement plan for its employees is faced with countless choices. Certain plans represent administrative ease. Other plans come with more favorable tax incentives. Still other plans provide flexibility. An employer can pick the funding arrangement, as to whether the employer or the employee or both will contribute to the retirement plan. Selecting the right plan is important, because it impacts the benefits received, the cost of operation, the employer's tax liability, perception by employees, and, ultimately, overall company profitability.

401(k) PROFIT SHARING PLANS

A profit sharing plan is a type of employer-sponsored retirement plan maintained with the intention of allowing employees to share in company profits. Nonetheless, the employer is neither required to have profits in order to make a contribution, nor do the contributions need to be made out of profits. Amounts contributed to the plan are tax-deductible to the employer. The contributions accumulate tax-deferred, and become taxable to the employee when distributed, either at retirement, or upon the occurrence of a specified event, such as death, disability, termination of employment, etc. The employer enjoys discretion in making contributions, and has a broad range of options in determining how the contributions will be allocated among various eligible employees

ADVANTAGES

  • • The employer contribution is completely discretionary.
  • • The employer can use the plan as a motivational tool in allowing employees to share in profits.
  • • A profit sharing plan may allow employee contributions, which can be matched.
  • • Flexibility in the allocation of contributions using any one of a number of formulas:
    1. (a) proportionate to compensation; or
    2. (b) proportionate to compensation adjusted for Social Security benefits; or
    3. (c) age-weighted, considering age and compensation as factors; or
    4. (d) a new comparability allocation formula, which allows the employer to maintain flexibility in allocation as long as the results can project and prove comparable benefits are paid at normal retirement age.
  • • A non-profit organization, church or governmental entity may also sponsor a profit sharing plan.
  • • A profit sharing plan may permit early withdrawals (for instance, under certain hardship circumstances) and plan loans.
  • • A profit sharing plan may provide incidental benefits such as life, accident or health insurance.

POSSIBLE DISADVANTAGES

  • • The employer is expected to make “substantial and recurring” contributions.
  • • The deduction limit may be lower than in a defined benefit pension plan.
  • • The level of benefits that may be provided is potentially not as high as in a defined benefit pension plan.
  • • There are limited restrictions on the withdrawal of profit sharing funds, for example, generally speaking, the funds must have been in the plan for two years before they can be withdrawn, and only if the document allows it.

ANALYSIS

Profit sharing plans have become more attractive since EGTRRA increased the deduction limit in profit sharing plans from 15% to 25% of aggregate eligible compensation. New comparability (tiered) plans offer the appealing option of the employer being able to target certain groups of employees for higher benefits.

EXAMPLE

– FOR ILLUSTRATION PURPOSES ONLY
Age Comp. Pro Rata SS – Integrated Age – Weighted Tiered
HCE1 60 $245,000 $49,000 $49,000 $49,000 $49,000
NHCE1 21 $30,000 $6,000 $5,035 $900 $1,500
NHCE2 25 $40,000 $8,000 $6,714 $1,200 $2,000
NHCE3 60 $50,000 $10,000 $8,392 $10,000 $2,500
NHCE4 45 $60,000 $12,000 $10,071 $3,530 $3,000
Total $180,000 $36,000 $30,213 $15,630 $9,000
Grand Total $425,000 $85,000 $79,213 $64,630 $58,000

CONCLUSION

Profit sharing plans continue to be one of the most popular types of plans adopted owing to their flexibility in contributions and allocations, as well as their substantial deduction limits. It helps that they are also one of only two defined contribution plan types that allows employee pre-tax contributions. All these factors contribute to the ability of profit sharing plans to be customized for the particular retirement plan objectives of individual employers.