Profit-Sharing—Age and Service Weigh In
For quite some time, profit-sharing plans have been recognized by many small business owners and professionals as effective, qualified retirement savings mechanisms. Generally speaking, these plans allow employees to share company profits. Two popular plans are the age-weighted profit-sharing plan and the service-weighted profit-sharing plan. With such plans, it's possible to base contributions on a participant's age or length of service, as well as salary, thus benefiting older participants and loyal employees without running afoul of Internal Revenue Service (IRS) nondiscrimination requirements.
The IRS allows employers to determine contributions using age as a significant factor because such calculations account for the fewer years an older plan participant may have to accumulate significant funds for retirement. Since contributions for younger participants will have much more time to earn interest than would contributions for older participants, the rules permit lower allocations for younger participants and higher allocations for older employees. The plan will not be disqualified as long as the projected benefits do not discriminate in favor of older, higher-paid employees.
Taking a Closer Look
The uniform points allocation formula is generally used to determine benefits for an age-weighted or service-weighted profit-sharing plan. This formula factors in an employee's age or length of service by assigning a predetermined number of points for each year of age, or each year of service, or both. For example, each employee may receive ten points for each year of age. An employee who is age 25 receives 250 points, whereas, an employee who is age 55 receives 550 points. All employees receive the same number of points for each year of age or service, and some plans set a maximum age or service limit.
The formula may also assign points for compensation as well, for example, one point for every $100 of compensation. However, the points assigned for units of compensation cannot exceed units of $200. Each participant's total points are equal to the sum of: (1) the total points based on years of service, if provided by the formula; (2) the total points based on years of age, if provided by the formula; and (3) the total points based on units of compensation, if provided by the formula. The allocation to each participant's account is determined by multiplying the employer's contribution by a fraction: The numerator of which is the total points assigned to the participant and the denominator of which is the total points assigned to all participants. The formula determines not only an allocation of contributions, but also an allocation rate, used for nondiscrimination purposes, which is a percentage that represents an employee's yearly compensation divided by his or her contribution allocation. In order for a plan to be nondiscriminatory, the average allocation rate of highly compensated employees may not be greater than the average allocation rate of employees who earn less.
Both types of profit-sharing plans must also define the requirements for distributing funds, which generally may happen after a fixed number of years, the attainment of a specified age, or in certain cases of hardship—such as illness, disability, or termination of service.
Before Moving Ahead...
Age-weighted and service-weighted profit-sharing plans are some of the most flexible types of qualified plans available, and can be ideal for small businesses. However, as with all planning matters, every situation is different and has its own variables and circumstances. Thus, it is generally prudent to consult a qualified financial professional to determine the best type of plan for your needs.