A profit sharing plan is a qualified plan in which eligible employees receive a contribution from the profits of the sponsoring employer. These contributions are usually discretionary and may change from year to year. This is a great way to give employees a sense of ownership in the company.
Profit Sharing plans can be combined with a salary deferral feature and are subject to many of the same reporting, testing, and document requirements as a traditional 401(k) plan. As with 401(k) plans, profit sharing plans can be designed to meet the unique needs of each employer through different allocation methods as outlined below:
Traditional Pro Rata Method
In a traditional allocation, employers will give the same percentages to all employees. For example, they might choose to give 5% of pay to each eligible participant or allocate a specific dollar amount according to each employee’s compensation as a percentage of the total compensation. Best for: Employers who want everyone to share equally and prefer a simple method of allocation.
New Comparability or Cross-Tested Profit Sharing Plan
In this type of plan, the employer segregates the eligible employees into “non-discriminatory” categories (i.e., job description, title, hourly vs. salaried, etc.) and designates different contribution rates for each group. This type of plan is normally designed to favor the HCEs or older employees. However, it can be designed to favor any group of employees assuming the annual nondiscrimination requirements are satisfied. Best For: Employers who want to give different amounts to different classes of employees, typically the higher amounts are given to owners or key employees.
Age Weighted Profit Sharing Plans
The age weighted profit sharing plan allows employers to make contributions based on an employee’s age and salary. This option offers those closest to retirement the ability to receive larger contributions than younger employees. Best for: An age weighted plan is typically used when all of your key employees are much older than the non-key employees.
Integrated Profit Sharing Plans
This type of allocation method is integrated with an overall retirement scenario that includes Social Security; this combination is called “permitted disparity.” By providing for permitted disparity in a qualified retirement plan, the employer gets the benefit of its Social Security tax payments. Employees with compensation above the Social Security wage base are allowed an additional contribution on that amount. This shifts the allocation to favor the higher paid employees without the complicated testing of an age weighted or new comparability plan. It favors higher paid employees by providing an additional share of the contribution to be based on compensation that would otherwise accrue minimal Social Security benefits or none at all. Best For: Employers that wish to benefit higher paid employees who are the same age or younger than other employees.