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