WHY THE EMPLOYER CONTRIBUTION TO A PROFIT SHARING PLAN NEED NOT BE ALLOCATED EQUALLY AMONG PLAN PARTICIPANTS
Many employers contemplating the establishment of a profit sharing plan mistakenly think its contribution must be allocating in a uniform manner among participants. It is a fact that the allocation may not discriminate in favor of owners and highly paid employers. The rank and file employees must be treated fairly. Thus, the Plan must meet certain non-discriminatory test in order to be a qualified plan.
Additionally, in the context of a defined contribution plan, the amount of the employer's annual contribution to the plan is discretionary. In the event of a year in which profits are less than for most years, the employer may skip making a contribution or contribute much less than it normally does.
Age-weighted and new comparability allocation methods may be tested for non-discriminatory purposes on either a benefits or a contributions basis. An example for an age-weighted allocation is given below to point out why testing on a benefits basis is not discriminatory in situations in which there are discriminatory among the ages of participants.
We will look to a subcontractor, owner of the employer, age 55 and his helper age 30. The owner has ten years left before he attains age 65. Under the age-weighted method of allocating employer's contribution, the employer must pass the General test using "cross-testing" (i.e., projected future benefits derived from the present-day allocation to the helper muster be comparable to projected future benefits derived from the present-day allocation to the owner.
If we use the same "testing age" (i.e., 65) and the same interest rate and mortality assumptions, both the owner and the helper are to receive comparable benefits at age 65. However, the lump sum accumulations to pay those benefits must also comparable. In order to accumulate comparable lump sums at age 65, using the same interest (between 7.5% and 8.5%) and the same mortality assumptions, the annual allocations for the owner must be much larger than those for the helper. Not only is the lion's share of the employer's contribution allocated to the owner, the total contribution both of them is much smaller because of the young age of the helper. Most small business owners see this as a win-win situation.
Following is an illustration of the power of interest compounding and the importance of investing early in life:
Bill invest $2,000 at the beginning of each year beginning at age 19 and continuing through age 26. Bill makes no additional investments to the account after age 26. For simplicity, we assume Bill's account earns 10% annually, compounded annually. At age 65, Bill's account balance is $1,035,160. Bill's total investment for the eight years totaled $ 16,000. Money earned on money is the wealth creator.
Phil begins investing $2,000 at the beginning of each year at age 27. Phil continues investing $2,000 annually through age 65. Phil's account balance after his investment for age 65 is $883,185. Phil's total investment is $78,000 over 39 years. Again, money earned on money is the factor that creates wealth.