What is an incentive plan?
A profit-sharing plan is a pension plan that gives employees a share of the profits of a business. Under this type of plan, also known as a deferred profit sharing plan (DPSP), an employee receives a percentage of a company’s profits based on their quarterly or annual earnings. It’s a great way for a company to give employees a sense of belonging to the company, but there are usually restrictions on when and how a person can withdraw these funds without penalties.
Key points to remember
- A profit-sharing plan gives employees a share of their company’s profits based on its quarterly or annual income.
- It is up to the company to decide how much of its profits it wants to share.
- Contributions to a profit-sharing plan are made by the company only; employees can’t make them either.
Understanding profit sharing plans
So how does profit sharing work? Well, for starters, a profit sharing plan is a retirement plan that accepts discretionary employer contributions. This means that a pension plan with employee contributions, such as a 401 (k) or something similar, is not a profit sharing plan, because of personal contributions.
Because employers set up incentive plans, companies decide how much they want to allocate to each employee. A company that offers an incentive plan adjusts it if necessary, sometimes making zero contributions in certain years. However, in the years in which it contributes, the company must find a fixed formula for the distribution of profits.
The most common way for a business to determine the allocation of an incentive plan is to use the comp-to-comp method. Using this calculation, an employer first calculates the total amount of compensation for all of its employees. Then, to determine the percentage of the profit-sharing plan to which an employee is entitled, the company divides the annual remuneration of each employee by this total. To arrive at the amount due to the employee, this percentage is multiplied by the amount of total shared benefits.
The most common formula used by a business to determine a distribution of profit sharing is called the “comp-to-comp method”.
An example of a profit sharing plan
Suppose a company with only two employees uses a compensation-for-compensation method for profit sharing. In this case, employee A earns $ 50,000 per year and employee B earns $ 100,000 per year. If the business owner shares 10% of the annual profits and the business earns $ 100,000 in a fiscal year, the company distributes the share of the profits as follows:
Employee A = ($ 100,000 X 0.10) X ($ 50,000 / $ 150,000), or $ 3,333.33, while employee B = ($ 100,000 X 0.10) X ($ 100,000 / $ 150,000), or $ 6,666.67.
The contribution limit for a company sharing its profits with an employee for 2020.
Requirements for a profit sharing plan
A profit-sharing plan is available for a business of any size, and a business can create one even if it already has other pension plans. In addition, a company has great flexibility in the way of implementing a profit-sharing plan. As with a 401 (k) plan, an employer is free to decide how and when to contribute. However, all companies must demonstrate that a profit-sharing plan does not discriminate in favor of highly paid employees.
As of 2020, the contribution limit for a company sharing its profits with an employee is the lesser of 25% of the employee’s compensation or $ 57,000. In addition, the amount of an employee’s salary that can be taken into account for a profit-sharing plan is limited, in 2020, to $ 285,000.
To implement an incentive plan, all businesses must complete an Internal Revenue Service form 5500 and disclose all participants in the plan. Early withdrawals, as with other pension plans, are subject to penalties, with a few exceptions.