Plan Types and Provisions

Profit-Sharing Plans

Profit-sharing plans all have common features.

• The contribution formula can be discretionary.
• The maximum employer contribution that can be deducted is 25% of the compensation of covered employees.
• The contribution can be determined annually by the board of directors of the company.
• Employer contribution accounts can be subject to vesting.
• Investment of contributions can be directed by the trustee or participant.
• Contributions may be based on profits, but profits are not required in order for a contribution to be made.

The primary distinction among the various types of profit-sharing plans is in the allocation of contributions.

Basic Profit-Sharing Plan

Contributions to a basic profit-sharing plan are generally allocated to eligible employees in the same ratio as each participant's salary is to the total salary for the group. Contributions can be integrated with social security to provide a higher ratio of contributions to participants who earn more than the social security wage base.

Age-Weighted Profit-Sharing Plan

As the name would suggest, age-weighted profit-sharing plans take into consideration the age of participants, as well as compensation, when determining the amount to allocate to each participant. Older participants receive a proportionately greater share of the allocation than younger participants as compared to a basic profit-sharing plan.

New Comparability Profit-Sharing Plan

Also referred to as a cross-tested plan, a new comparability plan allows the employer to divide employees into several groups and allocate different contribution rates to each group.

These plans are required to pass complex discrimination tests in order to meet Internal Revenue Service requirements so the administration cost may be higher than other plan types. The advantage is that the employer may be able to contribute greater amounts for a select group of key employees, while minimizing the cost for other employees.

401(k) Profit-Sharing Plan

401(k) refers to a section of the Internal Revenue Code that allows employees to make voluntary, deductible contributions to an employer-sponsored profit-sharing plan. Any type of profit-sharing plan can include a 401(k) provision. In fact, you cannot have a 401(k) plan unless it is part of a profit-sharing plan.

EGTRRA has significantly increased the amount an employee can contribute to an employer's profit-sharing plan through salary deferral.

In addition, EGTRRA added a provision to allow participants ages 50 and older a "Catch-Up" deferral.

Some Benefits:

• Employees receive an immediate tax deferral on contributions, and the earnings also accumulate tax-deferred.
• Many profit-sharing plans will match salary deferrals, increasing the benefit to the employees.
• Discretionary profit-sharing contribution can be made in addition to salary deferrals and matching contributions.

Some disadvantages:

• Additional discrimination testing is required, increasing administrative cost.
• If participation is low, highly compensated employees may be limited in the amount they can defer.

Safe Harbor 401(k) Profit-Sharing Plan

A Safe Harbor 401(k) plan is the same as a regular 401(k) plan with one exception: the employer makes a Safe Harbor contribution in lieu of performing discrimination testing. Accordingly, Highly Compensated Employees (HCEs) are allowed to contribute the maximum without regard to the participation of other employees.

The employer has two options for the Safe Harbor contribution:

• A matching contribution equal to 100% of the first 3% of an employee's salary deferral, plus 50% of the next 2% of an employee's salary deferral; or
• A 3% non-elective contribution for all eligible employees.

The Safe Harbor contribution eliminates the disadvantages of a 401(k) plan listed above. However, the Safe Harbor 401(k) Plan has two disadvantages of its own:

• The employer must commit to the Safe Harbor contribution at the beginning of the year.
• Employees are always 100% vested in the Safe Harbor contribution account.

Including a Safe Harbor 401(k) provision in a New Comparability Profit-Sharing Plan may provide a unique solution for a small business wanting to establish a retirement plan.

The following chart demonstrates various profit-sharing allocation methods.