Chapter 22: Profit Sharing Plan

Distributions

-Benefits usually payable at termination of employment, death, permanent disability, or retirement -Payable in a lump sum or a series of installment payments I-n-service distributions: benefits payable for hardship or age 59 ½ before termination of service -10% early distribution penalty may apply to distributions prior to age 59 ½ -Loan provision permits loans without early distribution penalty

Tax Implications for Employers

-Employer contributions deductible when made -Maximum deductible employer contribution may not exceed 25% of the payroll of all covered employees -If employer also has a defined benefit plan covering some of the same employees, deductible contribution is limited -Some employers eligible for business tax credit

Advantages

-Maximum contribution flexibility for employer -Contributions can be made even if no profits -Provides a tax-deferred retirement savings medium for employees -Simple, inexpensive plan -Tax deductible for employers; tax deferred for employees

Alternatives

-Money purchase pension plans: employer required to make contributions -Cross-tested, age-weighted, and target benefit plans: favorable for older employees -Defined benefit plans: provide more security; more complex; employer assumes investment risk -Nonqualified deferred compensation plans: executives and highly compensated employees -Individual retirement saving: little or no tax benefit

Investments

-Pool account Managed by employer Trust fund or group or individual insurance contracts can be used -Participant-invested account Limited number of possible investments to reduce administration costs Participants direct investments and take responsibility Employer or plan fiduciary responsible for selecting and monitoring investment options

Disadvantages

-Retirement benefits may be inadequate for older employees entering the plan -Relative amount of plan funding available for highly compensated employees is more limited -Employees bear investment risk under the plan -Level of employer funding less predictable

Tax Implications for Employees

-Taxation deferred until amounts withdrawn -Annual additions limited to lesser of 100% of employee's compensation or $53,000 (2015) -Annual additions include Employer contributions Forfeitures allocated to participants' accounts Employee contributions

When is it used?

-When employer's profits vary from year to year - When employer wants an incentive feature -when employer wants to supplement an existing defined benefit plan

. L. Timber, age 40, works for Treeline, Inc., a logging company. Treeline uses both compensation and service as a basis for allocating Treeline's $20,000 annual contribution to Treeline's profit sharing plan. How much would be allocated to T. L.'s account if he received 40 units of credit for his 20 years of service and 160 units for $80,000 in earnings? Total units for all employees are 1,000 a. $ 100 b. $2,000 c. $4,000 d. $8,000 e. need more information to calculate

4,000

Sandy Beech earns $40,000 as a guide for Tropical Tours, Inc. Tropical Tours typically contributes 10% of profit to their profit sharing plan. Total payroll for Tropical Tours is $120,000. This year, Topical Tours will contribute $21,000 to their profit sharing plan. Sandy's share this year will be: a. $3,000 b. $4,000 c. $7,000 d. $12,000 e. need more information to calculate

7,000

What is it?

A tax qualified, defined contribution plan featuring a flexible employer contribution provision

Allocation to Participant Accounts

All plans must have formula for allocating employer contributions to participant accounts -Cannot discriminate in favor of highly compensated employees -"Compensation" must be defined in nondiscriminatory way -Amount of compensation taken into account is limited -Can be based on compensation or years of service, integrated with Social Security

Employer Contribution Arrangements

Employer contributions based on- Discretionary provision: employer decides if, when, and how much to contribute Nondiscretionary formula: employer must contribute amount or percentage annually

Vesting

Generally, vesting provisions permitted by Code can be used Many use two-to-six-year vesting provisions Forfeitures (nonvested amounts "forfeited" upon leaving early) Reduces employer contributions Pay plan expenses Contributed to participants' accounts Formula for allocating forfeitures usually same as that used for allocating employer contributions

Social Security Integration

Maximum difference between the excess contribution percentage and the base contribution percentage depends on the earnings level (integration level) Integration level can be taxable wage base (TWB) used for Social Security purposes In defined contribution plan, integration level can't be higher than TWB

Social Security Integration

Most want it to be just above the compensation level of the highest paid nonowner employee Choosing an optimum integration level is complicated Might or might not increase owner's benefit

Purchases of Life Insurance

Participants can direct the plan trustee to purchase life insurance on the life of a person in whom participant has an insurable interest Plan must permit directed investment Plan must permit purchase of life insurance Amount governed by incidental limits

Social Security Integration

Standalone plan integrated with Social Security Employer costs reduced Employer contribution disproportionately allocated to higher paid employees Integrate defined contribution plan by contributing at a higher rate for compensation above certain earnings (excess contribution percentage)

An advantage of a profit sharing plan from the employer's point of view includes which of the following? a. employer contributions to the plan are discretionary b. plan can benefit long term employees c. non-vested benefits can be reallocated to remaining employees d. allows integration with Social Security e. all of the above

all of above

Which of the following is (are) true regarding vesting in a profit sharing plan a. cliff vesting can be used in profit sharing plans b. plan forfeitures can be reallocated in proportions that favor owners and highly compensated employees c. vesting provisions favor long term employees d. a and c e. forfeitures are typically returned to the employer's general assets.

d

A disadvantage of profit sharing plans is that a. employee bears the investment risk b. actuarial costs make the plan expensive to administer c. there is no predictable level of employer funding under the plan d. a and b e. a and c

e

Evergreen Semiconductors, Inc. is a young and innovative company with 25 employees between 24 and 35 years of age. Turnover has averaged about 2% per year for the 9 year old company. Profit has been intermittent. The owners believe that a substantial investment will need to be made in new equipment next year. Which of the following retirement savings plans is best for Evergreen? a. money purchase plan b. target benefit plan c. nonqualified deferred compensation plan d. defined benefit plan e. profit sharing plan

e

John Wald has participated in his company's profit sharing plan for the past 15 years and currently has an account balance of $250,000. Last month, his 12-year-old son had to have an emergency appendectomy. Complications extended his hospital stay to a week. Right before the accident, John used all of the family savings to purchase a new car. John must pay a $2,000 deductible and an additional $5,000 for medical expenses not covered under his medical plan. If John withdraws $7,000 from his profit sharing plan, a. he is in big trouble since withdrawals from a profit sharing plan are not allowed by law b. he must pay income tax and a 10% penalty on the amount withdrawn c. he must pay income tax, but face only a 5% penalty for early withdrawal since it is a hardship withdrawal d. all withdrawals from a profit sharing plan are penalty free, but income tax must be paid e. he would pay income tax, but no early withdrawal penalty to the extent the medical expenses are tax deductible

e

Employees who take out a loan from their profit sharing plan must pay 10% of the loan amount as a penalty as well as reasonable interest on the funds borrowed.

false

If an employer has a profit, at least some contribution must be made that year to the profit sharing plan.

false

In a profit-sharing plan, forfeitures may be reallocated or used to reduce future employer contributions

true