A profit sharing contribution is a discretionary employer contribution made on behalf of plan participants.
As with nearly all retirement plans, contributions to profit sharing plans and the growth in the value of plan investments are not subject to income tax until the participant receives a distribution.
Each year the employer contributes from 0% to 25% of each participant’s compensation to the plan (to a maximum of $57,000 for each participant in 2020). The contribution may be allocated in one of many ways.
The most common method is to contribute the same percentage of pay for each participant.
Alternatively, the employer may use a Social Security integration formula, which allows employers to increase the percentage of pay contributed on compensation in excess of the Social Security taxable wage base ($137,700 in 2020).
Other allocation methods include age weighting and cross-tested methods. Cross-testing divides the participants into two or more groups, with a different contribution percentage for each group. This type of allocation must pass a special nondiscrimination test and generally benefits smaller employers whose more highly paid employees and owners tend to be significantly older than other employees.
Each formula has its own benefits and limitations. The best fit for an employer depends on their objectives and the age and compensation of the participants.
Contact us today if you are interested in exploring the possibility of setting up a customized profit sharing plan to meet your retirement goals.
Learn more about 401(k) Plans →