Deferred Profit Sharing Plan

Article byKumar Rahul
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Deferred Profit Sharing Plan (DPSP)?

A deferred profit-sharing plan (DPSP) is a retirement savings vehicle designed to provide employees with a share of the profits earned by their employer. In a DPSP, an employer contributes a portion of its profits to the plan on behalf of eligible employees. The primary aim of a DPSP is to motivate and reward employees by linking their financial well-being to the company’s success.

Deferred Profit Sharing Plan

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By deferring the distribution of profits until retirement, employees are encouraged to remain with the company long-term, fostering loyalty and commitment. DPSPs can also serve as a valuable retirement savings tool, allowing employees to accumulate wealth over their working years. One of the critical features of DPSPs is that contributions are not deducted from an employee’s current income, providing a tax advantage.

Key Takeaways

  • Deferred Profit Sharing Plans (DPSPs) are employer-sponsored retirement savings plans designed to share a portion of the company’s profits with eligible employees.
  • Employers contribute to the DPSP based on a predetermined formula, often tied to factors like employee salary or company profits.
  • Contributions made by the employer are not included in an employee’s current income, providing a tax benefit. The funds in the DPSP grow tax-deferred until withdrawal.
  • DPSPs serve as a dedicated retirement savings vehicle, aiming to provide employees with financial security during their retirement years.

How Does A Deferred Profit Sharing Plan Work?

A deferred profit-sharing plan allows employers to allocate a portion of their profits to a retirement savings plan for eligible employees. The contributions are typically based on a predetermined formula, such as a percentage of an employee’s salary or the company’s profits. Importantly, these contributions are made by the employer and are not deducted from the employee’s current income, providing a tax advantage.

The deferred aspect of a DPSP comes into play as the contributions are set aside and invested, growing tax-deferred until the employee reaches retirement age. Unlike some other retirement plans, the distribution of funds from a DPSP is delayed until retirement, at which point employees can begin receiving regular payments or choose a lump sum.

Employees may also have the flexibility to choose how their contributions are invested, often selecting from a range of investment options offered within the plan. The ultimate goal is to provide employees with a source of income during their retirement years while fostering a sense of loyalty and engagement by tying their financial well-being to the success of the company.

Requirements

There are common elements that are typically considered in the implementation of DPSPs:

  1. Employer Eligibility: The employer must decide which employees can participate in the DPSP. Eligibility criteria often include factors such as length of service, job classification, or minimum hours worked.
  2. Contribution Formula: Employers must establish an explicit formula for determining how contributions are calculated. This may involve a percentage of an employee’s salary or a share of the company’s profits.
  3. Vesting Periods: Some DPSPs have vesting periods during which employees gradually gain ownership of employer contributions. This encourages employee retention over the long term.
  4. Investment Options: Employers typically offer a range of investment options within the DPSP, allowing employees to choose how their contributions are invested.
  5. Withdrawal Rules: DPSPs often have rules regarding when and how employees can access the funds. Typically, withdrawals are allowed upon retirement, but some plans may allow for earlier access under certain circumstances.
  6. Communication and Education: Employers are encouraged to communicate the details of the DPSP clearly to employees, providing education about how the plan works, its benefits, and how employees can make informed decisions about their contributions and investments.

Examples

Let us understand it better with the help of examples:

Example #1

Suppose a large technology company, XYZ Tech, implements a Deferred Profit Sharing Plan (DPSP) for its employees. In this scenario, eligible employees, based on factors like years of service, receive contributions from XYZ Tech, calculated as a percentage of their annual salary. These contributions are then invested in a diversified portfolio of stocks and bonds within the DPSP.

The funds in the DPSP have grown tax-deferred over the years, providing employees with a retirement savings vehicle. Upon reaching retirement age, employees can choose to receive regular payments from the DPSP or opt for a lump sum distribution.

Example #2

Canada’s Bill C-30, receiving Royal Assent in 2021, implements provisions from the 2021 federal budget with significant impacts on workplaces. Noteworthy changes include amendments to the Pension Benefits Standards Act (PBSA), allowing the Minister of Finance to designate entities for unclaimed pension assets. Federally regulated negotiated contribution plans (NCPs) face new registration provisions. At the same time, the Income Tax Act introduces Advanced Life Deferred Annuities (ALDAs) for retirees aged 85 or older, accessible via transfers from registered plans, including deferred profit-sharing plans.

Variable-Payment Life Annuities (VPLAs) offer a new decumulation option for defined contribution plan members. Amendments also address Individual Pension Plans (IPPs), specified multiemployer pension plans (SMEPs), and employee life and health trusts (ELHTs). The Canada Labour Code changes, include a CA $15 minimum wage and expanded leave entitlements, impacting federally regulated employers. Notably, the legislation needs to include administrative changes for correcting contribution errors in DC plans from the 2021 budget.

Taxation

The taxation of a deferred profit-sharing plan is based on the principle of tax deferral. Contributions made by the employer to the DPSP are not included in the employee’s current income, providing an immediate tax benefit. Instead, the funds in the DPSP grow tax-deferred until they are withdrawn by the employee, typically during retirement.

Upon withdrawal, the amounts taken from the DPSP are treated as income in the year they are received. This means that employees are taxed on the funds at their applicable income tax rates at the time of withdrawal. The idea behind this taxation approach is that individuals are likely to be in a lower tax bracket during retirement, potentially resulting in tax savings compared to when the contributions were initially made.

It’s important to note that specific tax rules and rates can vary by jurisdiction, and changes in tax regulations may impact the taxation of DPSPs. Additionally, there may be provisions for exceptional circumstances, such as financial hardship or disability, which could affect the taxation of withdrawals.

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Advantages

Let’s take a look at its advantages:

Advantages For Employers

  1. Employee Retention: Offering a deferred profit-sharing plan can enhance employee loyalty and retention by providing a long-term financial incentive. Employees may be more likely to stay with a company that shares its profits with them.
  2. Tax Benefits: Contributions to a DPSP are tax-deductible for the employer, providing a potential tax advantage. This allows the company to allocate a portion of its profits to employee benefits while reducing its taxable income.
  3. Competitive Benefits Package: A DPSP can be a valuable component of an employer’s benefits package, making the company more attractive to potential hires and helping to remain competitive in the labor market.

Advantages For Employees

  1. Retirement Savings: DPSPs provide employees with a dedicated retirement savings vehicle. Contributions made by the employer, along with potential investment growth, contribute to financial security in retirement.
  2. Tax Deferral: Employees benefit from the tax deferral on contributions as the funds grow tax-free until withdrawal. This can result in tax savings, especially if individuals are in a lower tax bracket during retirement.
  3. Financial Incentive: Knowing that their employer shares profits with them through a DPSP can act as a financial incentive, fostering a sense of ownership and encouraging employees to contribute to the company’s success.

Deferred Profit Sharing Plan vs RRSP(Registered Retirement Savings Plan)

Below is a brief differentiation between the Deferred Profit Sharing Plan and RRSP.

FeatureDeferred Profit Sharing Plan (DPSP)Registered Retirement Savings Plan (RRSP)
PurposeDesigned to share employer profits with employees and encourage long-term commitment.A personal retirement savings plan for individuals to save for their own retirement.
ContributionsPrimarily made by the employer, although some plans may allow employee contributions.Solely funded by the individual, with potential employer contributions in some cases.
Tax Treatment – ContributionsEmployer contributions are tax-deductible for the employer.Contributions are tax-deductible for the individual, reducing taxable income.
Tax Treatment – WithdrawalsWithdrawals are taxed as income in the year they are received.Withdrawals are taxed as income in the year they are received.
Withdrawal EligibilityTypically, withdrawals are allowed upon retirement, although some plans may allow for earlier access under certain circumstances.Withdrawals are generally allowed upon retirement, with restrictions on early withdrawals.
Investment OptionsOften includes a range of investment options within the plan.Individuals have control over their investment choices, with various options available.

Frequently Asked Questions (FAQs)

1. Who is eligible for a deferred profit-sharing plan?

Eligibility criteria vary by employer and may include factors like years of service, job classification, or minimum hours worked. Employers determine the specific criteria for employee participation.

2. Are employee contributions allowed in a deferred profit-sharing plan?

While DPSPs are primarily funded by employers, some plans may allow voluntary employee contributions. However, this is less common compared to employer contributions.

3. Can employees access deferred profit-sharing plan funds before retirement?

Generally, DPSP funds are for retirement, and withdrawals are allowed upon retirement. Some plans may have provisions for early withdrawals in specific circumstances, such as financial hardship.

4. Is there a maximum contribution limit for the deferred profit-sharing plan?

DPSPs do not have a specific annual contribution limit. However, there may be overall limits on tax-deferred contributions, and these can vary based on local regulations.

This article has been a guide to what is Deferred Profit Sharing Plan (DPSP). Here, we compare it with RRSP, explain its advantages, requirements, examples, and taxation. You may also find some useful articles here –

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