Profit sharing plans are retirement plans that allow companies to distribute a portion of their profits to their employees. It is estimated that roughly 25% of all U.S. firms offer profit sharing plans. For small businesses, profit sharing provides an important means of increasing employee loyalty and tying employee compensation to the performance of the company. Profit sharing plans are flexible in that there are no mandatory annual contributions. A company can choose to contribute when times are good and hold back during lean years.
There are two types of profit sharing plans. The first type is a cash or bonus plan. Employees are given a check from the companies’ profits at the end of the year. This leads to the employee being taxed on the profit sharing distribution. Contributions from this type of profit sharing plan can also be given in the form of stock. Even if this occurs, the employee is taxed on the value of the stock at the time given.
The more common type of profit sharing program is a deferred profit sharing plan. These are set up as qualified deferred profit sharing programs. In these plans, employees are not allowed to withdraw funds contributed by their employer. Therefore, the employee is not taxed immediately on the amount contributed by the employer. Often times these accounts are combined with 401k plans for consolidation purposes. Many times an employer will put a vesting schedule on the profit sharing contribution. These are put in place to show that the employee does not have immediate access to the funds and therefore avoids taxation. In addition, a vesting schedule discourages turnover and rewards longevity.
Profit sharing plans are often an important part of an overall financial plan. Many different types of investment options can be chosen to fund a profit sharing plan. Mutual funds are usually used. However, some plans can be funded with company stock or even an annuity. Profit sharing plans are defined contribution plans. Most companies do not want to manage the assets for their employees due to fiduciary liabilities.
If you are an employer looking to set up a profit sharing plan or an employee with a profit sharing plan of your employer, please do not hesitate to contact us with any questions. Clay Northam Wealth Management have offices in Los Angeles, and Seal Beach.
Note: Investing in mutual funds involves risk, including possible loss of principal.