Profit sharing plans are retirement plans in which employers share profits with employees through discretionary contributions based on earnings.
401(k)s are a type of profit sharing plan with capped employer contributions.
The advantages of profit sharing plans are tax deferrals and the fact that they can be used as incentives for better performance.
The disadvantage of profit sharing plans is that they are discretionary, meaning employer contributions are not mandatory or guaranteed.
The administration costs for a profit sharing plan are also higher than those for standard retirement plans.
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Profit sharing plans are also known as deferred profit sharing plans and are popular with small businesses and companies with few employees.
The flexibility of such plans appeals to employers because they can manage cash flow based on their earnings for a given year.
Unlike other retirement plans, which require mandatory annual contributions, a business owner can make no contributions to the plan one year and several thousands of dollars the next.
The maximum limit contribution for a profit sharing plan is capped at the lower of either $69,000 or 25% of an employee’s salary for 2024.
The maximum contribution amount that can be considered for a profit sharing plan is $290,000 or 100 percent of an employee’s compensation, whichever is lower, for 2024.
Profit sharing plans are especially attractive to senior employees of a firm because they enable such employees to sock away more of their salary for retirement purposes.
Those over the age of 50 can make up to $7,500 in catch up contributions to a profit-sharing plan, bringing the total amount for their annual contributions to $69,000.
A profit sharing plan comes with strict non-discrimination clauses and, generally, employers offer profit sharing plans to all employees.
However, companies can exclude employees from a profit sharing plan based on the following reasons:
There are three ways in which companies calculate the profit figure to be shared with employees.
Suppose company ABC has ten employees and has a profit sharing pool (the percentage of its profits that it has set aside for a profit sharing plan) of $100,000 for a given year.
It has decided to share 10% from the pool with each employee. Therefore, it will credit each employee’s profit sharing plan with $10,000.
In the example above, let us assume that the combined compensation of all ABC employees is $500,000. Dividing the profits among employees means that each one is entitled to receive 20% ($100,000/$500,000) of their total salary.
In this method, a gateway contribution, equal to a percentage of the employee’s compensation, is established for certain highly-compensated workers.
Such workers are senior employees or owners. Next, a percentage contribution, regardless of seniority or position, for each employee is calculated. to ensure that all of them receive the same benefit amount when they retire.
In the example above, a gateway contribution, equal to 2% of her salary, is set aside for Susan because she is a senior employee.
She is also allowed to put away a greater percentage of her salary as compared to Mark, who is a junior employee and does not have as many years of service as her.
This is because Mark has more time to make contributions and reach Susan’s payout.
The advantages of profit sharing plans are as follows:
The disadvantages of profit sharing plans are as follows:
Profit-sharing plans are retirement plans in which employers share profits with employees through discretionary contributions based on earnings.
The maximum limit contribution for a Profit-Sharing Plan is capped at the lower of either $69,000 or 25% of an employee’s salary for 2024. The maximum contribution amount that can be considered for a profit sharing plan is $290,000 or 100 percent of an employee’s compensation, whichever is lower, for 2024.
There are three ways to calculate profit share in a profit-sharing plan: flat amount contribution, comp-to-comp, and a comparability profit sharing allocation.
Profit-sharing plans are popular with small businesses and companies with few employees. The flexibility of such plans appeals to employers because they can manage cash flow based on their earnings for a given year. Unlike other retirement plans, which require mandatory annual contributions, a business owner can make no contributions to the plan one year and several thousands of dollars the next.
They are more expensive to administer as compared to traditional profit sharing plans because they contain substantial non-discrimination clauses that must be tested each year.
About the Author
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.
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