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Profit Sharing Plans: One Way to Share the Business Pie

As the name implies, a profit sharing plan is a plan that lets employees share in the company’s profits. Many businesses like profit-sharing plans because contributions are discretionary—if profits are down for a particular year, the business can lower its contribution percentage, or make no contribution at all.

And many employees like them because the plans enable them to share financially in the company’s success, giving employees a greater sense of ownership in the business. Profit-sharing contributions can also be a valuable source of retirement income.

Used as a Retirement Plan
Deferred profit-sharing plans (as opposed to cash profit-sharing plans — more details on these below) are basically profit-sharing plans that are used as a retirement benefit. They must be designed to benefit both rank-and-file employees and owners and executives, with contribution amounts that are proportional for all employees. In other words, owners and executives cannot receive a greater proportional financial benefit than other employees.

A separate profit-sharing account is established for each employee, and employers create a formula for determining how much money will be contributed to the plan (for example, a pre-determined percentage of the company’s pre-tax profits). In 2012, up to 25 percent each employee’s compensation or $50,000, whichever is less, can be contributed to his or her profit-sharing account.

In general, all employees must be included in a deferred profit-sharing plan, although employers may be able to exclude employees who are under age 21 and those who have not yet completed either one or two full years of service with the company.

Employees can invest the money contributed to their profit-sharing accounts in stocks, mutual funds and other investment vehicles if they choose. These contributions and earnings generally are not subject to federal or state income taxes until the employee begins making distributions.

Deferred profit-sharing plans can be designed so that contributions become vested over time, according to a vesting schedule. However, if at least two years of service are required in order for employees to participate, all contributions must be vested immediately.

Deferred profit-sharing plans are similar to 401(k)s plan in terms of penalties that may be assessed if funds are withdrawn before retirement. A 10 percent penalty is usually assessed on withdrawals made before age 59½, on top of income taxes that must be paid at ordinary income tax rates.

Used as a Bonus Plan

Instead of a deferred profit-sharing plan, an employer may offer a cash profit-sharing plan. This is not a retirement plan; instead, it operates more like a bonus plan.

Each employee's share of profits is paid directly to him or her in cash or company stock, and these bonuses are taxed when paid (just like wages) at ordinary income tax rates. Employees have immediate access to their allocations, with no penalties for accessing the money before retirement like there are with deferred profit-sharing plans.

With a cash profit-sharing plan, the employer can determine whether or not employees who leave the company before the allocation is paid out are eligible to receive any money. Many of these plans require that individuals still be employed by the company at the time of allocation in order to receive funds—this way, the business doesn’t have to share profits with employees who no longer work at the company.

To learn more about profit-sharing plans and other retirement savings options, please contact David Lerner Associates at (877) 367-5960.

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