Employers can use a profit-sharing plan to make discretionary retirement contributions for their employees.
Commonly referred to as defined contribution plan.
Do I Qualify for the Profit-Sharing Plan?
A profit-sharing plan is a type of defined contribution plan that allows employers to make retirement contributions for their employees. Contributions are discretionary and can be made in any year, even if the business doesn’t earn a profit.
2022 Profit-Sharing Plan Details
A profit-sharing plan is a type of defined contribution retirement plan allowed under the Internal Revenue Code. To be eligible for the tax benefits available to qualified plans, a profit-sharing plan must meet certain requirements, including:
• Protection from diversion (Plan assets cannot be diverted to purposes other than the exclusive benefit of employees and their beneficiaries.)
• Compliance with nondiscrimination rules (The plan can’t discriminate in favor of highly compensated employees.)
• Compliance with contribution and benefits limits.
• Compliance with minimum vesting standards.
• Compliance with plan participation rules.
What Are Discretionary Contributions?
Employer contributions to a profit-sharing plan are “discretionary,” which means the employer can decide how much it will contribute to the pension plan each year, if anything. There is no requirement to contribute, regardless of whether the business shows a profit for the year. (Exception: Self-employed individuals must be able to show net earnings from self-employment in a year in order to contribute to a profit-sharing plan on their own behalf.) This flexibility makes it a great retirement plan option for businesses of any size, especially smaller ones.
The maximum employer deduction for a profit-sharing plan is the lesser of 25% of compensation or the current annual dollar limit (as adjusted for inflation) and self-employed individuals (i.e., Schedule C businesses) may only deduct 20% of net earnings. Employer contributions to a profit-sharing plan may be 100% of earned income up to the annual contribution limits. The business must determine how it will allocate contributions among the participants and distribute accumulated funds to employees after they reach a certain age, after a fixed number of years or upon the occurrence of certain other conditions.
Benefits of Profit-Sharing Plans for Employees
The benefit employees receive is a combination of the employer contributions and the income, expenses, gains, losses and forfeitures arising from the investments held in the account. Employees cannot contribute to the plan, but they may be able to choose where the employer contributions are invested from options available in the plan.
There Are Thousands of Other Tax Planning Strategies You May Be Missing Out On
Learn how Prosperity Tax Advisors can help you save money in taxes.
• Can have other retirement plans
• Available to any size business
• Flexible annual contributions (contributions are strictly discretionary)
• Good plan if cash flow is an issue
• Must file a Form 5500 Annual Return/Report of Employee Benefit Plan with the IRS
• Administrative costs may be higher than under more basic arrangements (e.g., SEP IRA or SIMPLE IRA plans)
• Must show that benefits do not discriminate in favor of highly compensated employees
• Employer contributions only (If a salary deferral feature is added to a profit-sharing plan, it becomes a 401(k) plan.)
Assumptions When Taking the Profit-Sharing Plan
• The employer wishes to make the maximum allowable contribution for employees.
• Individual employees are capped at the lesser of 25% of compensation or the current annual limit.
• None noted.
Requirements to Claim the Profit-Sharing Plan
• Employees cannot make voluntary contributions to the profit-sharing plan.
• The plan must file a Form 5500 annually with the IRS.
Business Entities That Can Claim the Profit-Sharing Plan
• Schedule C
• Schedule F
• S Corporation
• C Corporation
The material discussed on this page is meant for general illustration and/or informational purposes only and is not to be construed as investment, tax, or legal advice. You must exercise your own independent professional judgment, recognizing that advice should not be based on unreasonable factual or legal assumptions or unreasonably rely upon representations of the client or others. Further, any advice you provide in connection with tax return preparation must comply in full with the requirements of IRS Circular 230.