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Profit Sharing Plans
Profit Sharing Plans
What Are Profit-Sharing Arrangements? Profit-sharing plans are a specific form of qualified retirement plan called a “defined contribution plan” in which the employer makes periodic contributions to the plan. Each employee’s retirement benefit depends on the amount of the employer’s contributions plus the investment performance of each employee’s account. While the employer is obligated to make the specifi ed contributions, the employee bears the risk of investment performance. These plans may be set up so employees can invest and manage their individual accounts.
How Do Profit-Sharing Plans Work? A distinguishing feature of profit-sharing plans is that employer contributions are not required every year. However, contributions must be “recurring and substantial.” Contributions in at least three out of every five years usually satisfy this requirement. The employer has flexibility in determining how and when to make contributions. For example, the amounts can be based on company profits in excess of a certain amount, a percentage of the company’s net income, or an annual determination by the board of directors. While contributions are deductible, they are limited to 25% of the participating employees’ total compensation.
How Are Contributions Determined? Employer contributions are often based on the employee’s total compensation, which can include salary, commissions, bonuses, overtime pay, etc. The maximum compensation that can be taken into account is $270,000 in 2017. In addition to limits on the employer’s deduction, there are also limits on the annual additions made to a participant’s account. These additions can’t exceed the lesser of 100% of the employee’s includible compensation or $54,000 in 2017.
What Are the Benefits? Profit-sharing plans enjoy the usual advantages of other types of qualified retirement plans, including employer contributions that are tax deductible (within limits) and not taxed to the employee when they’re made. Investment earnings also accumulate on a tax-deferred basis. Profit-sharing plans are generally attractive to companies with relatively young owner-employees, widely fluctuating profits, and a desire to avoid being committed to annual contributions. Another attractive option is the opportunity to include a 401(k) feature that permits employees to make elective salary deferrals to the plan. Profit-sharing plans off er a convenient, tax-advantaged way to prepare for retirement, while still allowing contribution decisions to be based on sound business practices.