Return to Retirement Plans       

Traditional Profit Sharing Plan

The Basics: Employer contributions to the plan need not be a specific percentage and they need not be made every year, as long as they are "recurring and substantial." Profits are not required in order to make a contribution.

How It Works

A. Employer contributions are tax deductible. IRC Sec. 404(a)

B. Contributions are not taxed currently to the employee. IRC Sec. 402(a) and 403(a)

C. Earnings accumulate income tax-deterred. IRC Sec. 501(a)

D. Distributions can be tax-favored (eligible for 5-year forward averaging2 or rolled over into an IRA) at retirement. IRC Sec. 402 and 403

Additional Considerations

A. Maximum Annual Deduction: Up to 15% of covered payroll can be contributed and deducted by the employer.

B. Contribution Base: Plan contributions are normally based on total compensation; e.g., base salary, bonuses; overtime, etc. The maximum compensation recognized in 1999 is $160,000.

C. Individual Limits: The allocation of contributions to a participant's account may not exceed the lesser of 25% of includable compensation or S30,000 per year.

Employer Contributions

A. Most plans are discretionary as to the amount which the employer contributes.

B. If there are profits; the employer is expected to make -"substantial and recurring" contributions. As a rule of thumb, contributions during three out of five years or five out of 10 years will usually gain IRS approval.

Excluding Persons: Certain persons can be eliminated on the basis of months of service age and coverage in a union plan; for example, persons under age 21 can be excluded from the plan.

Investment Plan of Assets: Investments must be diversified and prudent. Subject to plan provisions, plan assets may be invested in equity products like mutual funds, stocks, and debt-free real estate.

Soda Security Integration: Since the employer already contributes to the employee's Social Security retirement benefit. These contributions can be integrated into the allocation formula of the plan.

Forfeitures: As participants leave the company and separate from the plan, those less than 1.00% vested forfeit that part of the account in which they are not vested. The non-vested forfeitures may then be allocated to the remaining participants. Those participants who remain in the plan the longest will share in the most forfeitures.

Parties which are Favored: Typically younger participants are favored because they have a longer time for their fund to grow and share in forfeitures.

How Much Will There Be At Retirement?

This will depend upon three factors:

A. The frequency and amount of contributions,
B. The number of years until retirement
C. The investment return.

The risk of poor investment returns rests upon the employee. However, if the investment results are favorable, the participant will have a larger fund at retirement age.

    An Example of What $10,000 Per Year Will Grow to Over Several Years at Various Rates of Growth Without Tax
Years 6% 9% 12% 15%
5 $56,371 $59,847 $63,528 $67,424
10 131,808 151,929 175,487 209,037
15 232,760 293,609 372,797 475,804
20 367,856 511,601 702,524 1,024,436
25 548,645 847,009 1,333,339 2,127,930
30 790,582 1,363,075 2,413,327 4,347,451
35 1,114,348 2,157,108 4,316,635 8,811,702

The results shown are hypothetical and simplified to facilitate understanding.

Top-Heavy Plans

If more than 60% of the plan assets are allocated to key employees, then the employer must contribute at least as much for participants as it does for key employees. This requirement applies only to a contribution of up to the first 3% of includable compensation (higher in some instances).

Advantages To Employer

  1. Contributions are tax deductible.
  2. Contributions And Costs are totally flexible.
  3. The plan is easy to understand by the employees.
  4. Forfeitures of terminating employees may reduce future costs or be
    reallocated among the accounts of those in the plan.
  5. It can provide employees with permanent life insurance benefits that need not expire or require costly conversion at retirement age.
  6. The employer can direct investments.
  7. Coordination with social security will reduce contributions for employees.

Advantages To Employees

  1. Annual employer contributions &e not taxed to the participant.
  2. Earnings on the account are not currently taxed.
  3. Distributions at retirement may be tax-favored.
  4. Participants can have the right to direct investments.
  5. Participants can also have a traditional, deductible IRA, or a Roth IRA,
    subject to certain income level limitations based on filing status.
  6. There is the ability to purchase significant permanent life insurance, which is
    not contingent upon the company.
  7. Younger employees can accumulate a larger fund than with a defined benefit
    plans. The forfeited, unvested portion of accounts of former participants may be
    reallocated to the active participants accounts. This can have a substantial
    impact on the future benefits.
  8. Employee can borrow from the plan within certain guidelines if provide for in the plan documents.

Disadvantages To Employer

A. The profit sharing plan will generally not produce as large a contribution and
     deduction for older employees as well as defined benefit plan.
B. Contribution limitations are set at 15% of covered payroll.

     

Disadvantages To Employees

A. There is no guarantee as to future benefits.
B. Investment risks rest on the participant.
C. Older participants may not receive as large a benefit as with a defined benefit plan.
D. There is no assurance as to the frequency and amount of employer contributions.