When it comes to retirement plans, there are many choices. One option that this article will dive into today, is the “profit sharing plan” which is a type of defined contribution plan that allows businesses to provide discretionary contributions -- meaning they can decide from year to year how much to contribute (or whether to contribute at all).

A profit sharing plan can be an attractive benefit for employers and employees alike. Employers can benefit from that flexibility and business tax deductions for amounts contributed, while employees benefit by accumulating tax-deferred retirement savings. Unlike 401(k) plans, profit sharing plans can only accept employer contributions; employee salary-deferral contributions are not allowed.

If your company decides to provide this type of defined contribution plan, employer contributions are not mandatory, as mentioned above. This means that in years where the company doesn’t turn a profit, the business doesn’t have to make contributions to employees’ profit sharing accounts. However, businesses of any size can start and contribute to a profit sharing plan whether or not the business is profitable.

Understanding Profit Sharing Contribution Options and Methods 

If your business decides to contribute to a profit sharing plan, there are several different methods you can use to determine contribution amounts. It’s important to carefully evaluate your options before choosing one, as once you make an election in your plan document, you can’t change it without amending or restating the plan. You’ll also need to make sure your contribution method complies with IRS nondiscrimination rules.

1. Salary Proportional Method/Salary Ratio Method

Under the salary ratio method, the company’s contributions are a flat percentage of each employee’s salary. This method is uniform, satisfying safe harbor requirements. While this is simple and straightforward, it could result in business owners funding lower-paid employees’ accounts at a higher level than they’d like in an attempt to maximize their own contributions.

2. Integration Method/Permitted Disparity Method

The permitted disparity method, also sometimes known as “Social Security Integration,” recognizes social security benefits earned in excess of the taxable wage base. Because of this, the percentage contributed for higher-income earners can be greater than the percentage for lower-income workers. However, the amount contributed for rank-and-file employees can still be high and can result in a less-than-ideal percentage allocated to the owner.

3. New Comparability Method/Age-Weighted Method

Alternatively, the new comparability and age-weighted methods may help businesses maximize contributions to the owner’s account while reducing the cost associated with contributing to non-owner employees’ accounts. The age-weighted method considers the participants’ ages and their compensation while the new comparability method allows employers to divide employees into different groups and allocate different percentages to each group. When considering using one of these methods, cross-testing is necessary to ensure benefits for highly-compensated employees are comparable to those for non-highly compensated employees. Keep in mind that “comparable” does not mean equal.

Profit Sharing Plan Rules and Regulations 

A complete discussion about profit sharing plans is outside the scope of this article. However, understanding the rules governing plan compliance can help your company avoid potential issues later.

The following resources are just a few that include valuable information about profit sharing regulations including rules related to participation, contributions, vesting, nondiscrimination, investments, employers’ fiduciary responsibilities, and more:

• U.S. Department of Labor: Profit Sharing Plans for Small Businesses
• IRS: Choosing a Retirement Plan: Profit Sharing Plan
• IRS: Tax Information for Retirement Plans

Evaluate Your Options Carefully and Consult Financial, Tax, and Legal Professionals as Needed 

Implementing and contributing to a profit sharing plan can be a wise move for your business, the owners, and your employees. Every business is different, so there is not a “one-size-fits-all” approach for designing your plan. The information presented in this article is designed to provide a high-level overview of contribution methods and important considerations. If you are considering establishing a profit sharing plan or are evaluating contribution methods, talk to qualified professionals who can help you evaluate and compare your options.