Profit sharing plans are retirement plans that are subject to the terms and conditions of the Employee Retirement Income Security Act. The legislation defines rules that a company must follow to offer a plan, including annual nondiscrimination testing and tax filings. It's good to become acquainted with the conditions and rules that govern participants in these types of plans.
The conditions that must be satisfied to make a plan qualified are numerous and specific. If any one of them is not met and an audit catches the problem, the plan could be reclassified as nonqualified. As a result, employees could end up owing taxes on all contributions made to their plans, as well as any growth in the assets dating back to the first contribution. Needless to say, that would decimate employee morale and would most likely lead to numerous lawsuits. The employer would face substantial penalties as well.
In profit sharing plans, there doesn't need to be a formula that ties the contributions to company profits. For example, 10 percent of your annual salary might be used. Another common method is for the company to allocate a fixed amount. The firm might look at the payroll and calculate each employee's share. It is also common for companies to base this allocation on age and service. In addition, there are combined plans. Many profit sharing plans have added 401k features. This means you might have three "buckets" of money in one account: profit sharing, 401k contributions and possibly a company matching contribution. The trend toward such combined plans is based mostly on employee requests. If a company offers a profit sharing plan, allowing employees to contribute their own salary doesn't add much cost, just administrative maintenance.
Qualified retirement plans are plans that are covered by ERISA. For a plan to be covered, it must meet a host of conditions ranging from the types of employees who may participate to the contribution limits. There is an initial process when the plan is created, as well as an annual recertification process to maintain qualified status. The annual process to recertify the plan as qualified is called testing, and a tax return for the plan (Form 5500) may be required.
A profit sharing plan specifies the contribution into the plan. The maximum tax-deferred amount of income you can receive in a year, known as the 415 limit, is $49,000 in 2009. Distributions from profit sharing plans carry significant restrictions on when and under what circumstances they can be made. Distributions may only be made if you separate from service or become disabled; a distribution may be made to your beneficiary if you are deceased. If you are under age 59 1/2 at the time of the distribution, a 10 percent penalty will apply in addition to income taxes on the amount of the distribution. Another distribution regulation is that beginning at age 70 1/2, mandatory distributions of a portion of your account balance are required.
In general, to be qualified under ERISA, a profit sharing plan must demonstrate the following:
- That it covers all employees equally (it can't favor top managers or other high paid employees) using a nondiscrimination test; exceptions can be made if everyone in the plan is highly paid (called a highly compensated employee, or HCE)
- That the benefits in the plan are given out to participants in an acceptable and fair way
- That the compensation used as a basis for the benefits is fair
- That the purpose of the plan is to benefit the plan participants.
Profit Sharing Plan vs. 401(k)
Profit-sharing plans and 401k plans share several similar features but also have specific differences. Understanding these is valuable for retirement planning.
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