Profit Sharing Plans are another popular retirement plan option available to small and mid-sized companies. They offer flexibility to employers and are easy to understand.

The contributions are not actually based on the profitability of the company, but rather on the compensation of the eligible employees. The company is allowed to contribute from 0% to 25% of eligible compensation on a pre-tax basis each year. The contributions are deposited into a separate Profit Sharing Trust using a separate Tax Identification Number (TIN). Profit Sharing Plans typically use a six-year graded vesting schedule. These Plans can also be established on a ‘standalone’ basis or combined with a 401(k) Plan. The contributions are allocated to participants based on one of the four following formulas:

Pro-Rata (Uniform) Formula

A traditional Profit Sharing Plan has a pro-rata (uniform) allocation formula. If the company contributes 10% of compensation into the Plan, than each eligible employee is allocated 10% of their compensation.

Integrated Formula

This type of plan allows Social Security benefits to be considered when testing for non-discrimination. Employees who have compensation greater than the Social Security cap do not receive the equivalent benefits of lower paid employees when you combine profit sharing contributions and Social Security benefits. As a result, employees with compensation greater than the Social Security Taxable Wage Base in effect for that year may receive an extra contribution to even out the overall benefits.

Age-Weighted Formula

This formula uses age as well as compensation to allocate profit sharing contributions among eligible employees. Non-discrimination is proved based on the benefits the employees receive at retirement age. Older employees have less time to accumulate contributions before retirement consequently, they are permitted to receive higher allocations currently.

Tiered or Comparability or “Cross-Tested” Formula

This formula allows the employers to separate employees into different groups (or tiers). Each tier may have a different allocation formula subject to non-discrimination testing requirements. This type of plan allows the employer to specifically tailor the plan to the goals of the company and reward certain employees at higher levels than others. In its simplest form, Group (or Tier) A is defined as ‘owners’ and Group (or Tier) B is defined as ‘all other employees’.