What is a Profit Sharing Plan and How Does it Work?
Let’s start by answering what is a profit sharing plan?
A plan designed in which shares of the company’s profits are given to an employee as compensation. Any type or size of business can incorporate a Profit Sharing Plan. Employees get their profit shares or compensations either by cash or company stocks. Company’s can have a 401k and profit sharing plan.
This plan allows the employers to control it in however way they want to. The employers decide how much they want to contribute with a set formula* for profit allocations. Employers decide when to do it. If the company is not making enough profits, then contributions can be cease.
How does a profit sharing plan work?
Profit sharing plans allow participants to have another type of retirement plans at the same time. Employers can easily allocate contributions on their employees chosen retirement plan. Usually these contributions go to a 401k account. It helps the business defer tax liabilities from the money set aside for Profit-Sharing plans.
* The common set formula they use is the comp-to-comp method. It works by calculating the amount of annual compensations an employee has, divided by the sum of total compensations all participant employees. The result gives a percentage that sets how much shares the employee can have.
Profit Sharing Plan Contribution Limits
Employers have the ability to contribute up to the maximum profit sharing plan contribution limits per year. Depending on how the company is doing in profits, employers will decide how much they can give. The amount must be less than 25% of compensations.
Requirements for eligibility
- The employee must have the minimum age which is 21 years old. There is no age maximum, so anyone after age 21 is eligible.
- The employee must have at least one year of service in the business or company. The minimum hours required within that year is 1,000, without exceptions. The required number of hours must be met to be eligible.
- Be an U.S. Citizen or Permanent Resident Alien.
Type of Profit Sharing Plans
There are 3 types of profit sharing plans available:
- Cash Plan: Contributions from the employer can be cash, checks or stocks to the employee. The only disadvantage is that it can be part of employee’s income tax.
- Deferred Plan: Contributions are given on the long-run, either on retirement, death, disability or termination of the job. This plan exempts employees from paying federal taxes. Taxes are only paid until being withdrawn.
Profit Sharing Combination Plan:
It allows the employee to take allocate part of the contributions into his saving account and the other half as cash. The part allocated in his saving account doesn’t pay taxes until withdrawn. The other portion left that is given as cash, is taxed and must be paid immediately.
Profit Sharing Plan Benefits
- It can work as an employee incentive. This gives the employee a sense of ownership for its hard work in the business. It leads to success and a better relationship between employer and worker.
- Employees productivity increases, giving the business the opportunity to obtain better results. Workers start focusing more on increasing the company’s profitability.
- Contributions given to the participants can be used as a tax deduction for the company.
- The workers can also get tax deductions by getting contributions on their 401K, if decided. The contributions can get to grow tax deferred and only be taxed once withdrawn from account.
- The employer has complete control and flexibility over the plan. It allows them decide when and how much the contribution is.
- Helps the company pass the discrimination test. It demonstrates the company doesn’t take sides for the highly compensated employees.
- Companies that enroll on this plan can decide to either administer it themselves or hire someone else. By hiring a professional, it gives relief and trust to both employee and employer that things will go as desired.
- Stock options and other investment choices can be used as compensation. This allows the business to grow in the market share and surpass competition.
- Loans are available when needed for employees. The money comes from what is already vested on the participant savings account. Interest rates are reasonable and needs to be paid with payments at least quarterly.
- In case of moving or leaving current company employee can take what he has vested. This plan gives the participant the opportunity to move account into a Rollover IRA.
Difference between Profit Sharing and 401K Plans
These plans both have as focus to save money for an employee. They provide a certainty that money will be save up for retirement. Even though they share the same focus, they still have some differences. Some of this are:
- The one who contributes. In the Profit Sharing Plan the employer is the one who mainly contributes to the plan. Meanwhile, in the 401K Plan, the employee is the one contributing to his/her saving account.
- In a 401K plan withdrawal can only be made at retirement age, unless they approved to withdraw before for hardship expenses*. In the Profit Sharing Plan, early withdrawals can be made, having the obligation to pay a tax penalty.
- The Profit Sharing Plan gives employees a sense of ownership to employees which work as an incentive. Shares are given as contributions to employees which motivates them for more productivity and profitability. The 401K only provide employer’s contributions, but it doesn’t provide any sense of ownership.
- Way contributions are done. In the 401K plan contributions are either by a matching contribution or a non-elective contribution. In the Profit Sharing Plan contributions depend on compensations of the employees.
*The IRS determines if a hardship withdrawal can be done. Hardship expenses examples can be: no reimbursement of medical expenses, funeral expenses, purchase of employee’s principal residence, prevent eviction or foreclosure of principal residence, repairs to damages on principal residence, or for educational costs for 12 months for beneficiary’s family.
A Profit Sharing Plan does not only compensate employees, but it also shares the success. This type of plan improves loyalty, productivity, and employer-employee relationship.
The flexibility this plan provides for contributions can be easily under supervision and control. The employer controls how everything goes on it. The can control which amount, how, and when.
Employees need to be notified before the plan becomes active. The employer needs to notify the benefits, rights and features that are going to be provided. Also, a Summary Plan Description (SPD) which informs participants what is the plan about and how it operates.
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