When it comes to rewarding employees for their work and retaining employees through benefits and incentives programs, companies have a wide range of options. Lately, a popular choice has been the profit-sharing plan. To help you understand the rules and value of profit-sharing plans, we’ve explained the most common features of the plans below.
A profit-sharing plan allows employers to share the financial success of the business with employees through a systematic, regulated process. While plans must adhere to rules created by the IRS and the Department of Labor, the regulations allow business owners considerable latitude in terms of contributions, employee eligibility, and vesting.
The IRS requires that discretionary contributions by employers to profit-sharing plans be “substantial and recurring.” In general, this rule is interpreted to mean that contributions should take place a minimum of two out of every five years. Contributions are usually related to company profits; however, contributions may be made in years where companies do not experience any profits. It is important for participants to recognize that their employer is not required to make contributions every year.
Employer contributions are limited to the lesser of 100% of an employee’s compensation or $51,000 in 2013. However, employers cannot deduct from taxes amounts above 25% of compensation; therefore, it is rare to see amounts contributed to employees that are above 25% of compensation. In general, basic profit-sharing programs allow for contributions by employers only.
Once contributions have been made, the funds are allocated to employee accounts by a pre-determined formula that cannot be discriminatory in favor of highly-compensated executives. Common formulas take into account years of service, level of employment, and compensation model.
The Department of Labor and the IRS also provide business owners with guidance in designing employee eligibility for plan participation. Again, plan sponsors may not be discriminatory against any group. They can, however, exclude employees who have not attained age 21, have not completed a year (sometimes 2 years) of service, or are part of a collective bargaining agreement (labor union).
Vesting rules describe the process by which employees who participate in profit-sharing plans receive ownership in the contributions made to the plan on their behalf. Remember, profit-sharing plans are designed to encourage and retain workers; as a result, business owners may elect to slowly relinquish ownership of profit-sharing funds to plan participants. There are two basic vesting schedules available to employers. Under the three-year schedule, workers are 100% vested after three years of service. The six-year graduated schedule allows workers to become 20% vested after two years and to vest at a rate of 20% each year thereafter until they are 100% vested after six years of service. If the plan requires two years of service prior to participation, employees are immediately vested. Plans may have faster vesting schedules, but may not be more restrictive than the schedules outlined above. Also noteworthy is the rule that employees must be 100% vested by their “normal retirement age.”
If a profit-sharing plan is part of your benefits package and you’re an eligible participant in the plan, you’re entitled to view the plan’s Summary Plan Description (SPD). The SPD contains an explanation of the rules governing the plan. We encourage you to review your plan at least annually and share the details with your financial adviser. After all, the funds in the plan may be a signification portion of your long-term retirement plan.
Andrea L. Blackwelder, CFP®, ChFC and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with Wisdom Wealth Strategies.