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Profit sharing plans are one of the simplest and yet one of the most flexible of all the defined contribution plans. The contribution is made by the employer to the plan and allocated to the participants based on a formula. The contribution may be discretionary or stated as a percent of profits. No contribution is necessary in years where there are no profits, but a contribution may be made even if there are no profits or accumulated profits. Employee after-tax contributions may be made, but they must pass an anti-discrimination test. This type of plan may be sponsored by any employers, even those in the non-profit or governmental sectors. Plans sponsored by non-profit or governmental employers are generally referred to as 401(a) plans.
Plan Provisions
Background
All profit sharing plans must have a definitely determinable allocation method. That is, the method used to allocate contributions to the individual participants must be specified in the plan document. There are various methods available to allocate the contributions. The benefit provided at normal retirement age is an account balance. There is no guarantee of benefits at normal retirement.
Employer Contribution Allocation Formulas
Allocation by Compensation
The IRS has defined allocating the employer non-elective contribution by a relationship of a participants compensation divided by the total of all participants compensation as a non-discriminatory method. This method gives each participant the same percentage of compensation as a contribution. Compensation must be limited to $225,000 for the 2007 plan year.
Integration with Social Security
Current regulations permit integration with Social Security. That is, the effect of social Security on the plan can be built into the allocation formula for the employer contribution. The plans take into consideration the fact that social Security provides a larger percentage of pay for the lower paid individuals and a smaller percentage of pay at the higher levels at retirement.
The plans are permitted to discriminate in favor of the highly compensated within the limits pro- vided by the IRS code. The amount of contribution for the highly compensated participants may be a larger percentage of pay than for the non-highly compensated participant.
Age Weighted Plans
The plan contribution is weighted based on the ages of the participant and the compensation of that participant. The plan is tested using the cross-testing rules to prove that it meets the non-discrimination rules.
Super Integrated or New Comparability Plans
The plan allocation is based on the class of an employee. All the employees are divided into classes by compensation levels or job groupings. Each class is tested and the highly compensated employee class is compared to the non-highly compensated group of employees. The plan is tested using the cross-testing rules to prove it meets the non-discrimination test.
Advantages and Disadvantages of Profit Sharing Plans
Advantages
Employers with varying profit levels may make a variable contribution amount, as needed each year. If the employer has a younger workforce and the participants and owners have a relatively long time to accumulate for retirement this plan can provide a greater retirement accumulation than can a defined benefit plan. If the employer is concerned about any type of fixed commitment to a retirement, this plan has the flexibility to allow for the varying levels of employer contributions. If the employer desires to have greater portability in benefits, the profit sharing plan provides for an account balance that may be transferred easily. If the employer desires to allow the participants to direct their own asset investments, this plan allows for the participants to profit from good self- direction of their own accounts. If the employer desires to shift the risk of asset return to the participants, this plan will place both the risks and rewards of asset return on the shoulders of the participants.
Disadvantages
The allocation of the employer contribution is based on compensation, and long service employees late in a career can not make up any missed contributions. The contribution for an individual employee is limited to the lesser of 100% of covered pay or $45,000. Adverse investment returns may hurt an older employee with no time for the investments to recover. Retired employees may outlive the retirement income. There are also no additional death benefits for surviving spouse or children in the plan years.