While choosing from the various kinds of retirement plans available, an employer or a company can choose a profit-sharing plan to provide retirement benefits for its employees.
What is a Profit-Sharing Plan?
Profit-sharing is a retirement plan that considers the employer's discretionary income. Unlike other retirement plans that require employees to contribute to the retirement plan, a profit-sharing plan puts the entire responsibility of funding on the employer.
The company can exercise its discretion while allocating its profits towards its employees' retirement goals. It can choose the amount to contribute each year out of the profits available. As a result, they may avoid making contributions in a “down year.”
A profit-sharing plan can be a powerful tool to boost employees' retirement goals while improving morale and productivity. In addition, it is a sure way of appreciating an employee's contribution to an organization.
How Profit-Sharing Plans Work
An employer shares its profit with its employees through the profit-sharing plan. When contributed to a specific employee fund, the funds become tax-deferred and are taxable only on withdrawal. A profit-sharing plan is at the employers' discretion, usually in addition to a traditional retirement plan like 401(k). The company can distribute profits through either a tax-deferred stock option or a cash bonus.
- Profit-sharing plans allow employers to distribute their discretionary profit to their employees, thereby boosting their motivation and improving employee retention in the process.
- Employer contributions are tax-deferred and taxable at the time of withdrawal.
- The money contributed helps secure the employee's retirement plans. They are invested in stocks, shares, and other instruments to help provide for their financial future.
- The primary drawback is that profit-sharing depends entirely on an employer's discretion. Because of this, a profit-sharing plan typically comes in addition to a traditional retirement plan like 401(k).
- It might attract a higher administrative cost.
All employees are usually eligible to participate in the plan, although the company might exclude some employees for the following reasons:
- They are below 21 years of age
- They do not have the necessary tenure of service (2 years in many cases)
- They are members of a trade union
- In the case of certain non-residents
Allocation of Contribution
An employer determines the extent of contribution by following the comp-to-comp method. The steps are:
- Determine the total compensation paid to all the employees.
- Divide the actual compensation of each employee by the total employee compensation to get a fraction.
- Multiply each employee's fraction by the total contribution allocated by the employer.
The employer can allocate profits using any of the three methods:
- Equal Contribution Plan: Profit is distributed equally to all the participating employees.
- Age-Based Plan: Employers contribute to the plan based on the age and the years of service of each participating employee.
- Variable-Rate Plan: Employers can contribute varied rates to each group of employees based on the factors they decide.
Employers can use the profit-sharing plan by contributing tax-deferred income in funds of the participating employees or in the form of a cash bonus depending on the company's profit in a particular year.
Maintaining Your Profit-Sharing Plan
A profit-sharing plan is made purely at the employer's discretion, depending on how much of the profit they desire to allocate towards the individual employee's retirement plans. Although the employer is free to allocate any amount they choose, the company must pay proportionately to all the participating employees of the company. The IRS has also fixed a limit on a company's total amount towards an individual employee account.
Limits of Contribution
In 2022, a company can share its profits with employees to the extent of 100 percent of employee's compensation or $61,000, whichever is less.
Further, the company must fill out Form 5500 to disclose the plan's details and its participating employees. Also, the company must report that it is not discriminating in favor of its highly-paid employees in the process.
Funds deposited by the company towards profit sharing are tax-deferred at the time of contribution but will be taxable at withdrawal. Withdrawal of funds is allowed on attaining the age of 50.5 years. It would attract an additional tax of 10 percent if withdrawn earlier.
A profit-sharing plan is an effective tool in the hands of the employers to provide retirement benefits to the employees and get a tax advantage in the process.