It turns out Jane Owner is not thrilled about contributing a large amount to the profit sharing plan for the benefit of John Employee. (See Spring/Summer Series Part 2.) She likes John, she thinks John is a good employee, but she doesn’t want to contribute 16% of pay for him. Go figure.
Fortunately for Jane, we have the age-based profit sharing plan. In a regular profit sharing plan, we look at the contributions as a percentage of pay. In an age-based plan, we look at the benefit the contribution would theoretically provide for the participants at age 65. A participant who is 30 (John) has more years for his contribution to grow than a participant who is 50 (Jane). Therefore, the contribution for Jane would have to be higher than the contribution for John to provide the same benefit. Quite a bit more, as it turns out. Using the age-based allocation and the same $40,000 total contribution, Jane now gets $38,102 and John gets $1,898. This, instead of $32,000 and $8,000 under the regular allocation.
“But what about next year?” asks Jane. “As you know from the census I provided to you, my new employee, Joan Staffworker, who makes $40,000 and is the same age as me (ie, 50) , will be eligible this coming January 1. Will the age-based allocation still work?”
Thank you for that exposition through dialogue, Jane, but sadly, no. That’s why we look to the new comparability profit sharing plan. With this type of allocation, we perform a sort of pension magic (which is to say, a complicated set of actuarial computations) and find that next year, if Jane wants the same level of contribution for herself, she will have to contribute $2,500 for John and $2,000 for Joan. It looks like Jane, with 69% of the total eligible compensation ($200,000/$290,000), is getting 89% of the contribution ($38,102/42,602). Not bad.
You may have noticed that both John and Joan get 5% of pay in our comparability allocation. This is a sort of optimal minimum level, under which Jane’s contribution as a percentage of pay would be limited to three times that of her employees. If John and Joan were to get only 3% of pay, Jane would be limited to 9% of pay. Not horrible, but not as good as our example.
So, what did this part of our Spring/Summer Series teach us? We now know that an age-based profit sharing plan is great when the owner is considerably older than her employees. We know that a comparability profit sharing plan can work well if only some of the employees are considerably younger than the owner. And we learned that exposition through dialogue, though hated by many authors, can be an effective means of conveying information in certain circumstances.
The main disadvantage to an age-based or comparability allocation? The employees are not contributing toward their own retirement benefit.
Next up: 401(k) plans
So, what is a profit sharing plan? The answer is obvious...it’s a plan to share profits, right? WRONG!
(OK, I promise not to do that again.)
Despite its name, making a contribution to a profit sharing plan is not contingent upon the employer’s profit. The reason for the misnomer is that such plans were originally designed to share profits, but that changed over time. Now we’re stuck with the straightforward-seeming name whether we like it or not.
So to answer my own question, a profit sharing plan is a means to provide employees with deferred compensation. In its simplest form, an employer makes a contribution to the plan, and each eligible employee (or participant) shares in that contribution based on the ratio of that participant’s pay to all participants’ pay. For example, 50 year old Jane Owner has a plan with two participants, herself and 30 year old John Employee. Jane’s compensation is $200,000 per year. John’s is $50,000 per year. Any contribution made to the plan will be allocated 80% to Jane and 20% to John. For 2019, the company contributes $40,000, with $32,000 going to Jane’s account and $8,000 going to John’s.
“But wait!” complains Jane. “I already contribute toward my employees’ retirement security in the form of Social Security, at least up to the Taxable Wage Base. Isn’t there some way I can contribute more for those (like myself, for instance) who earn more than the SSTWB?”
Why, yes, Jane, there is. It’s called Permitted Disparity. (In the old days, it used to be called “integrated with Social Security.” Some people still refer to it as such.) With Permitted Disparity, there is an allocation based on all pay, plus another allocation based on pay in excess of the SSTWB. In our example above, Jane would get 5.7% of $67,100 ($200,000 - $132,900), and then the rest would be allocated 80% to Jane and 20% to John. The resulting allocation is $32,765 for Jane and $7,235 for John.
As with all defined contribution plans, what the employee gets out of the plan depends on what goes in on his behalf plus investment growth. Longer term employees, in general, will have more contributions, more investment growth, and higher vesting, resulting in greater retirement security.
Some advantages of a (regular or permitted disparity) profit sharing plan:
Next up: age based and new comparability profit sharing plans.