What Are Profit Sharing Plans? | How Do They Work?

What Are Profit Sharing Plans? | How Do They Work?

A profit sharing plan is a type of retirement or bonus plan that lets large and small employers share profits with their employees. It’s an excellent way to reward employees for a profitable year or quarter, and contributions are tax-deductible. Profit sharing plans are very flexible, and they can help attract and keep talented people. Employers don’t need to commit to regular contributions, and they can offer other types of retirement and bonus plans as well. Keep reading for answers to some of the most frequently asked questions about profit sharing plans. 

How Does Profit Sharing Work?

To set up and start contributing to a profit sharing plan, business owners must decide how much they want to give to each employee. They can change this decision each year or quarter, and they can decide not to contribute anything if profits are too low. However, when they make contributions, companies must allocate them in a fair, nondiscriminatory way. 

Most organizations use the comp-to comp method. The employer calculates the total employee compensation budget for the year or quarter, and then they divide each individual’s salary by that number. The resulting percentages are multiplied by the total amount of the profits being shared. That way, employees with higher salaries get a larger portion of the total amount allocated to the plan. 

For example, a business that made 1 million dollars in profit could decide to share 10% of its profit or $100,000. The company’s yearly salary expenditure for all five employees was $800,000, and Michael, the lead salesperson, made $120,000 or 15% of that amount. The employer would contribute $15,000 to his profit sharing plan that year, 15% of $100,000.

What Types of Profit Sharing Plans Are Available?

Businesses can choose a deferred profit sharing plan (DPSP), a cash plan, or a combination plan. With a deferred plan, contributions are deposited into a trust fund, and employees don’t need to pay taxes on the money until they withdraw it. This helps interest accrue faster, making saving money for retirement easier. However, according to the IRS, employees who take money from a DPSP before age 59½ could have to pay an additional 10% in taxes. These plans are similar to 401(k)s, but employees don’t usually contribute. 

A cash profit sharing plan awards cash or company stocks directly to employees, and they must pay taxes on the money the same year they receive it. This type of plan works more as a bonus to motivate employees than a retirement benefit. With a combination plan, businesses can add some money to a trust fund to give employees later, and they can award some cash to people immediately.

What Rules Should Profit Sharing Plans Follow?

Profit sharing usually happens after the company determines its profitability for the year, before filing taxes. Employer contributions to all types of profit sharing plans are tax-deductible. According to the Department of Labor, companies that want to start a profit sharing plan must adopt a written plan document as the foundation for plan operations. Most companies get help creating this document from an investment advisor. Your plan document should include information about:

Which Employees Can Participate

Profit sharing plans can exclude employees under 21 years old, nonresident aliens, and people who have completed less than one or two years of service. Plans can also exclude employees covered by a collective bargaining agreement that mentions retirement benefits, employees who work fewer than 1,000 hours per year, and independent contractors.

Vesting Rules

If two years of service or more are required for plan participation, all contributions will be vested immediately after employees begin participating in the plan. If the service requirement before joining the profit sharing plan is one year or less, the plan may have a vesting schedule. The most common options are three-year cliff vesting or six-year graded vesting.

With cliff vesting, people get access to 100% of plan contributions after three years of participation. With a six-year graded vesting schedule, employees get access to 20% of contributions after two years and an additional 20% annually after that. This means that they would be able to withdraw 100% of contributions to their account after six years.

Provisions for a Trust With a Trustee to Handle the Plan’s Assets

The plan trustee and anyone they hire for help have a fiduciary duty to act in the best interests of plan participants. They must follow the plan document, diversify investments, attempt to keep costs low, and update the plan document if future changes in the law require it.

How Contributions Will Go to the Trust

The contribution limit for profit sharing plan in 2021 is 100% of the employee’s annual compensation or $58,000, whichever amount is less. When employers file their taxes, they can deduct up to 25% of the amount paid to all participants during the tax year.

A Formula and Rules for Allocating Contributions to Participants’ Accounts

Plans must provide benefits for regular employees, not just owners, managers, and executives. Some plans are subject to annual testing to make sure that contributions for regular employees are nondiscriminatory and proportional to the contributions made for owners and managers. They can let participants receive cash, transfer the money to an IRA or another retirement account, or choose periodic payments. Many plans let people choose between all three options.

Along with the plan document, businesses must create a Summary Plan Description (SPD) to inform plan participants and beneficiaries about the rules of the plan and how it will operate. Some plans let participants make their own investment decisions, and others make choices for them. SPDs for plans that let people make their own choices should include detailed information about investment fees and other expenses and projected returns.

Profit sharing plans must have accurate record keeping systems that record contributions, earnings, losses, investment decisions by the trustee or plan participants, expenses, and benefit distributions. If an administrator or financial institution helps manage the plan, they’ll usually keep the records. These records give businesses the information they need to file IRS Form 5500 and disclose all plan participants.

To learn more about profit sharing plans, contact us at Capstone Capital. We’re an independent, SEC-registered investment advisor in Henderson, Nevada, only about 20 minutes away from the heart of Las Vegas. Whether you’re a business owner or an individual, we can help you manage your investments and plan for retirement.


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